Friday, August 26, 2011

Derivatives Black Magic

Derivatives Black Magic

“Poor is spending 10% of your income on lottery tickets.
Frugal is putting 10% of your income in investing.
Poor is spending money. Frugal is saving money.
[...]
Poor is watching TV and wanting things.
Frugal is reading books and doing things...”
(“The Mental Prison of Being Poor” ~ Jakub Lund Fisker)



I have been investing in stock markets and precious metals in the past little while. Over the past three year a lot of people, including me, have been driven into dividend (and yield-) investing. If you cannot make money by buying low or selling high, you want to be paid for waiting.

What we have seen over the past couple months however, drove several “average” investors out of the market again. Stocks have been going down; markets went crazy, precious metals shot high. Ironically people like to buy things when they are going up and run crying from them when they are going down. Some people actually bet against such herd mentality make much money.

So if you find yourself in a similar situation and you want to increase your income, the obvious thing to do is to decrease your spending and increase your income again. Since my spending side did not offer much potential for cutting since I’m already somewhat frugal, working on the income side had the higher potential.

The Risky Part...

Disclaimer: If you indent to do what follows, you do it at your own risk. This is just a report on what I figured and no investment advice. There are substantial risks involved, some of which are mentioned at the end. If you’re a greedy person who never did options trading and shorting stocks before … skip this and take a part-time job :).

Ok here it becomes suicidal, because that approach stands against almost everything that was posted with regards investing on this blog so far. Being a vivid viewer of Max Keiser who is a declared enemy of the current banking establishment, I became a fan of precious metals. However, when you have been following his very cynical show about markets, finance scandals you actually realize how this bad establishment makes money. Derivatives and alternative investments (such as options) usually play a major role for the current crisis that we are in right now. Picking up a couple books on financial engineering and derivatives trading will actually provide you with some of the black magic (excluding insider trading) that people use to make money. I suggest anyone to get a financial education, so that you first of all do not get fooled by the hot real estate babe close by, avoid doing stupid investment mistakes, and realize how your savings are devalued; and a plus, you actually learn techniques that make you realize short term gains.

The idea of this technique is to pair derivatives with stocks to generate high-yield, low risk fixed income. The ingredients that you need for this black magic cocktail are:
  • Margin: An existing pool of assets that you can borrow against
  • Basic experience of shorting dividend-paying stocks
  • Basic experience of options trading
(OPTIONAL Step 1.) One way to not touch your existing investments is to borrow money against them. Most brokerages allow you to buy stocks on a margin. I’m not getting into detail of margin calls, maintenance margins here. But as a rule of thumb for most brokerages, the maximum you borrow needs to be backed up by 50% (usually large cap stocks) - 100% (penny stocks) of the other asset in your portfolio. That means you are on the brink of trouble (i.e. toast!!!!), when you borrow 20.000$ to buy a large cap stock against a 10.000$ portfolio. You are toast if the value of the asset you are borrowing against goes down, or the stuff you buy goes down. In addition, you have to pay interest on the margin (~4.5% at my brokerage). In short, do not leverage yourself too much.
So suicide banking lesson 101, you need something that you can borrow against. The “suicide bankers” in Max’s show usually leverage themselves 20-50 times over. However, they are doing it with their deposits and not their own money.

2.) Having established the risk of margin. You need to invest the borrowed money in a way that what ever you buy with that money does not go down. It is absolutely essential to mitigate downside risk if you take out margin. A rather unconventional way to do this is to buy a pair of investments; one investment that goes up when the other one goes down. This is referred to as a neutral position. You can do this for example by buying a stock and shorting it at the same time. If the value of the stock goes down, you make gains on the short position, if the value of the stock goes up you make money with the long position.
Since investing into individual stocks and short-selling individual stocks incurs management, you better buy ETFs that do this for you. In addition you’d be liable for all the dividends to be paid on your short position, which makes crunching the numbers harder.
On the web you can find various pairs of “bear” and “bull” ETFs for various investments. Better, some ETFs actually imitate the performance on the order of two (double-bear/bull) or three (triple-bear/bull). Since ETFs incur some marginal management fees and do not exactly track the inverse of the underlying asset, be prepared for some joyrides there. So up to this point you are not making money yet, instead you’re paying margin interest. Now the interesting part...

3.) Once you own a stock (whether bought on margin or not) you can write options on it. Options are usually used to insure against various risks. You can buy a put option to sell your stocks at a fixed price below the current purchasing price. You can buy a call option to reserve the right to purchase a stock at a fixed price. Buying such “insurance” against market conditions is expensive. But acting as the other party, who actually sells the insurance you can make money. The amount you make is usually determined by the volatility of the underlying asset and how you price the so called “strike-price”. If you’re reading this you should already know what I’m talking about here.
One thing that you can do is covered-call writing. In which you sell call-options above the current price of your asset (and hope it does not get there). Given the position we established earlier, you can write call options on the long side of your position, and pocket the call premium. In a very volatile market that we have right now, the premiums to be made are significant.
Since you are not a day trader, in order to minimize the management overhead you better buy a covered-call ETF directly that does this stuff for you.
If you manage to pair a covered-call ETF with a double- or triple-bear-ETF on the underlying asset you can actually magnify the returns. For example, (in theory!) in order to establish a neutral position you can take a 75% position in a covered-call ETF and a 25% position in a double-bear ETF, which means you (in theory!) mitigated all your downside risk and pocket about 75% of the premiums compared to a full position in the covered-call ETF.
Let’s crunch the numbers for a theoretical example. Let’s pick TSE:HEX (Covered-Call TSX60 ETF) and TSE:HXD (Double-Bear TSX60 ETF). Say you have taken out 25.000$ to invest, and your margin interest rate is 4.5%. At the time of writing the price for HEX is 8.63 and for HXD is 10.12. That makes up for the following

25000$ invested in
2170 shares of HEX ~ 18750$
617 shares of HXD ~ 6250$

The yield & maintenance costs:
HEX pays somewhere between 0.12$ - 0.14$ per share depending on the volatility of the market per month. That means you pocket

HEX distribution per month (assuming 0.12 ct): 260$

and you have to pay the margin interest on 25000$ ...

Interest on 25.000$ (assuming 4.5%) per month: 93.75$

So in theory you’d be pocketing a ball-park of approximately 150$ extra per month (~8% p.a. on the margin) on top of your current investments. That excludes trading commissions. In addition, you might have to re-balance the neutral position once in a while to remain neutral.

Note that in practice you make less! There substantial liquidity risk associated with these ETFs and those ETFs charge management fees. In addition you are falling for the volatility trap in the leveraged ETF. Do not use this technique for a very volatile instrument. Because if the leveraged position (i.e. 2x inverse ETF etc) does not follow a sustained tend, you loose money (as shown here). I have been monitoring a not fully neutral position and witnessed quite some divergence of both funds over the past while. Be prepared for a wild ride and to make a little less money. I highly suggest making a spreadsheet to monitor your initial- and re-balancing commissions, the interest payments, and your yield and portfolio value.

Once you establish your income, you can pay the margin down and gradually sell (some of) the down-side protection (if needed). Think about it as a money-printing machine that pays itself off. 
And especially for all those property virgins out there, think about how much you need borrow in order to buy and maintain a house or apartment to be able to rent out a room to a poor student to make like 200$ per month. I bet the risk involved in that calculation is much higher than “this gamble” described here. Note in order to qualify for a real-estate mortgage you would have to liquidate some of your savings in my scenario this would be the collateral that you borrow against to establish the neutral position. I have been able to make consistently between 5-8% in fixed income on that amount which is opportunity forgone when buying a house.

With respect to the introduction, think about this as frugal only if you’re not gambling on margin :).

Posted by Thomas Reidemeister at 1:55 PM

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