Requested Topic: Added Leverage

Mark,

I do quite a lot of market timing,
long term in nature. Similar length as 200 MA crossover, just to give you an
idea of the length. Normally I buy index ETFs like SPY or QQQQ.

I
wonder if there is a good way to add options instead – and if possible – add
some leverage to the strategy. The drawdowns I have are quite small (8-10%) and
my timing system would be even better with some leverage and I do think I can
live with 2-3 times the drawdown if the results go from today's 14% to
2 or 3x that amount.

Today when I add leverage I must pay interest for
margin. I guess options are a way to avoid this? I mean, add leverage without
need of extra capital. What are your thoughts here?

Thanks for your time.

HS

Sweden

[Note to rookies: MA = moving average.  'Drawdown' represents the maximum amount lost over period of time, before you once again become profitable]

Hej HS,

Your first priority is to not jeopardize your current results.  If you want to earn additional profits while minimizing risk, options can help.  The ideas I recommend require little margin, and you can meet that requirement by buying a few less shares of your ETF.

If you want additional leverage, the simplest strategy is to buy puts or calls.  I dislike that strategy in general – because it's too difficult to consistently make money – but in your situation, it's an especially poor idea.  As a longer-term trader, you would find yourself holding options and watching time eat away at the premium.  Buying options may be appropriate if you find a very short-term trade, but I don't think it's a good idea for you, unless you anticipate a LARGE market move.

As a long-term trader, you want to take advantage of the passage of time.  And because you earn decent profits, it appears that your methods are profitable.  Thus, I recommend a low risk, low margin strategy that you can use in conjunction with your normal purchase of ETFs.

Next time you have a bullish situation, instead of only buying ETFs, put 10% of your capital into selling out of the money (OTM) put spreads for a cash credit.  This requires no extra margin, and there are two advantages.  First, the ETF doesn't have to increase in value for you to earn a profit.  If SPY falls by a small amount, you still make money.  Second, because those option spreads expire in a relatively short time (choose 1-,2-,or 3-month spreads), you may have an opportunity to sell such spreads again and again during your longer-term cycle.

These spreads offer an opportunity to earn far more than 14% annually – but don't fall into the trap of believing it's easy  money.  If you use this method at appropriate times, you have the opportunity to make anywhere from 2 to 10% in a month or two.  It's important that you manage the risk of each spread, and not allow any to inflict a large loss – if the market moves against you over the short-term.  But, that's normal portfolio risk management.

You can sell call spreads when bearish.

Although I doubt you would ever use it, you can buy iron condors any time you are market neutral over the short term.

These are all limit loss/limited gain methods, but each has a small margin requirement and allows you to gain the advantage of collecting time decay. 

Of course, to be a consistent winner with these methods, your ability to pick direction must continue to be reasonably accurate.

Mark

82

4 Responses to Requested Topic: Added Leverage

  1. Roland 09/08/2008 at 7:21 PM #

    Hi Mark,
    I’m wondering how many trades you typically have on at any given time.

  2. Mark 09/09/2008 at 1:00 PM #

    I don’t really want to say because it’s far too many for the most traders and I do NOT want to encourage anyone to even consider carrying that many positions simultaneously.
    I have positions that expire in Sep, Oct, Nov and Dec. Including extra naked calls and puts that I BOUGHT, I have open positions (long or short) in more than 40 different RUT option series.
    Mark.

  3. Roland 09/09/2008 at 1:25 PM #

    I can’t imagine having anywhere near that of amount of trades on at once.
    I am initially looking at trading only Iron Condors. For now I am just wanting to put on trades that are 30 to 45 days out.
    I don’t want to put a huge percentage of my account into just one trade. But I don’t see how I could put on more than one or two trades a month because the sweet spot for risk vs premium is pretty narrow.

  4. Mark 09/09/2008 at 2:25 PM #

    1) Agree. It would be very foolish for you to have that many positions. That’s why I did not want to tell you how many positions I have. Why should you care how someone else trades?
    2) Your goal as a trader is not to copy me – or anyone else. You may want to see what others are doing – to generate ideas. But you MUST find your own comfort zone – and clearly having many positions violates that zone. You have chosen your strategy. Now find your comfort zone: how many positions, how far OTM to sell; how much credit to collect, etc.
    3) If this is your learning zone – i.e., iron condors are new to you – have a bit of patience. Open one position that expires in Oct and perhaps one in Nov. But not at the same time. Open one when ready, and then when the market makes a decent move – like yesterday or today – you can open the 2nd position using different strike prices.
    4) If managing two positions is easy and comfortable, you can consider opening 2 new ones after you close October. Either a 2nd Nov plus a Dec, or 2 Dec. That would give you three total. My guess is that you will prefer a total of two.
    5) Don’t concentrate on the sweet spot, unless your plan is to hold all the way until the end – and hope the options expire worthless. I find that far too risky, but if that’s your plan (and comfort zone), then your sweet spot depends on the strike prices you choose to sell.
    6) Agree that you should not trade one LARGE position. But that does not mean you must put all your money to work. Please begin slowly and benefit from trading experience.
    7) Paper trading is not for people afraid to use real money. It’s for people to LEARN and UNDERSTAND what they are doing. If you paper trade, you will see how many positions are good for you. And please believe me, there is nothing special about having many positions. I do it for reasons that I will not share. But you definitely want to trade a small quantity of iron condors. In fact, you may want to adopt other strategies at the same time (that’s a personal decision).
    But, it’s essential that you not lose track of what you own. Risk management is essential. If managing risk becomes too complicated, then do everything you can to make it easy – even if it means owning only a single position at any one time. There is NOTHING wrong with doing that.
    You will NOT make money every month. That’s a guarantee (my longest streak is 14 months and I doubt I’ll ever match that again). You must be
    ready and able to keep loses relatively small. That’s a facet of trading that you will discover for yourself as time passes.
    Mark