Should a BH investor never use futures/options?

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acegolfer
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Should a BH investor never use futures/options?

Post by acegolfer »

When should a long term buy and hold investor use futures/options?
afan
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Re: Should a BH investor never use futures/options?

Post by afan »

For most people, "never." There are some situations where it makes sense. If you get paid in part in stock options, the alternative to accepting them would be refusing them. People who produce commodities, say farmers, may use futures to reduce the volatility of their returns from selling their crops. If you are obligated to hold an undiversified portfolio, say you are an owner of a closely held business, then you need to limit your exposure to that risk. Futures or options could help.
I am sure there are other examples along these lines.
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Beliavsky
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Re: Should a BH investor never use futures/options?

Post by Beliavsky »

acegolfer wrote:When should a long term buy and hold investor use futures/options?
You can

(1) replicate Treasury bond positions in a tax-advantaged manner through Treasury bond futures.
(2) hedge currency risk in international stocks and bonds through currency futures
(3) get commodities exposure by purchasing commodity futures and rolling them
(4) rebalance a portfolio to desired allocations through stock and bond futures rather than selling assets with capital gains

Note that I used the word "can", not "should". I don't currently do any of these things. Unlike passive "cash" strategies, even passive futures strategies require ongoing activity, since contracts expire.
edge
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Re: Should a BH investor never use futures/options?

Post by edge »

You can use them to hedge your exposure to your own company's stock.
wolf359
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Re: Should a BH investor never use futures/options?

Post by wolf359 »

What about writing covered calls against your stash of index ETFs to generate income when in retirement?

If they get called, you can settle with cash, so you can still maintain your position and avoid capital gains. Most of the time, it will simply generate income.

This strategy isn't appropriate UNTIL retirement, because it generates short-term taxable income.
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Re: Should a BH investor never use futures/options?

Post by rob »

I have got a lot of my compensation from options in the past - less popular now than it used to be but still common in some industries; I'm not giving them up :D
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Re: Should a BH investor never use futures/options?

Post by wolf359 »

acegolfer wrote:When should a long term buy and hold investor use futures/options?
In my research, I identified DBC and DJP, which are ETFs that attempt to match commodities indexes for buy and hold investors. These ETFs hold futures contracts that match the index, then roll them over as they expire, to provide continuous coverage. They provide diversified commodity exposure if you want to include it as an asset class.

That said, I decided against them for myself. I don't understand commodities well enough, and I think there are execution problems with this way of matching an index. The expenses of doing this are too high for me.

If you want commodities exposure, this is one way to get it. The other way is to buy a basic materials sector fund (which is more closely correlated to equities, but still impacted by commodities prices). Basic materials sector funds avoid direct exposure to futures.
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Re: Should a BH investor never use futures/options?

Post by t3chiman »

acegolfer wrote:When should a long term buy and hold investor use futures/options?
A truism: most purchased options expire worthless. A corollary: most options make money for their sellers.
The classic amateur play is selling out of the money call options on stocks you own. It's easy to do, and can be fun, as long as you don't get greedy.
For instance, for a while, I owned 200sh of Royal Dutch Petroleum. It's one of the richest companies in the world, controls a strategically valued commodity, and pays 5% dividends (on a 60 dollar stock). Its price moves slowly, as do the prices of the associated call options. I recall that the options traded at 50 cents to a couple of dollars, depending. It was easy to sell a couple of options and feel good about making $300 or so free money. Lather, rinse, repeat; end up "making" a few extra percent, and tell yourself you are earning 8-9% on your investment.
Of course, much of this is a rationalization after the fact. Option selling is not as risky as option buying. But it does entail risk of loss and risk of missing out on gains. On a big dividend payer like RDS.B, the risks are minimal, and it can be fun. If you try it with, say, Intuitive Surgical, be aware you are playing in traffic. It's only money, but still...
In terms of investment philosophy, the effort involved is slight, but is in opposition to the "Hold" part of Buy-and-Hold, and is somewhat at odds with Boglehead wisdom regarding trading, timing, etc.. And if you are a conservative personality type, you can just google "Vanguard high yield", and end up with funds that do better than your probable net efforts in the options game.
Hope this helps.
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Re: Should a BH investor never use futures/options?

Post by Tanelorn »

t3chiman wrote:A truism: most purchased options expire worthless. A corollary: most options make money for their sellers.
Just because most options end up worthless doesn't mean you should sell them. With a short option, all you can make is 100% (if it ends up worthless), but that doesn't make up for losing 1000% if the short position moves against you a lot unless the good outcome happens 10x as often.
The classic amateur play is selling out of the money call options on stocks you own.
Right, because amateurs don't notice how they get the stock called early and it goes on to double without them getting most of that money. For them it looks like "free money" unless the stock goes up a lot, and then they can rationalize it as having still sold and made a profit. It can easily be a negative expected return strategy, just one with easy psychological justifications.
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Re: Should a BH investor never use futures/options?

Post by White Coat Investor »

I agree, no free lunch there.
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Re: Should a BH investor never use futures/options?

Post by t3chiman »

Tanelorn wrote: With a short option, all you can make is 100% (if it ends up worthless), but that doesn't make up for losing 1000% if the short position moves against you...
The nightmare of unlimited losses from a short option position is possible only if your are writing naked calls. Writing covered call options (ie options on stocks you already own) is a very conservative strategy, approved for IRA accounts for instance. And what's wrong with making 100%?
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Re: Should a BH investor never use futures/options?

Post by 691175002 »

Options as an investment are about the purest violation of the Bogle philosophy possible.

Recall that the decision to avoid active mutual funds is because on the whole it is a zero-sum game (or negative-sum after transaction costs). Outperformance of one manager must necessarily come at the cost of another manager since there are two sides to every trade.

Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative. Any dollar you make is a dollar someone else has directly lost.

You can argue that the diversification provided by options and other alternative (or even active) strategies can make them desirable on a risk-adjusted basis but then the discussion becomes more involved.
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Re: Should a BH investor never use futures/options?

Post by Elbowman »

691175002 wrote:Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative.
This is not mentioned enough! You are playing a negative-sum game (after costs) against professionals. That should be all you need to know to discard this idea.
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Re: Should a BH investor never use futures/options?

Post by 691175002 »

t3chiman wrote:The nightmare of unlimited losses from a short option position is possible only if your are writing naked calls. Writing covered call options (ie options on stocks you already own) is a very conservative strategy, approved for IRA accounts for instance. And what's wrong with making 100%?
That is true in a purely literal sense, but I think it misrepresents risk.

For example, consider writing options with a strike 5% above the market. If we go into a situation where the market crashes 30% one year and then is up 35% the next, you have lost roughly 30% by writing that call.
Sure, you can point out the option did lead not to a direct loss of capital, but you have still wiped out many years of option premiums in a very short time period.

Options have a very skewed risk profile so with this strategy you are expected to make a small amount of money most of the time, and take large losses (relative to the benchmark) very rarely. This is why most measures of risk (ex: standard deviation or beta) are not recommended when looking at option strategies.

I'm not saying that writing covered calls is necessarily a bad strategy - the reduction in return volatility might be a good tradeoff (which I alluded to by mentioning risk-adjusted returns). I'm just saying that there are many ways to look at risk, and the covered call strategy might be riskier than it looks.
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Re: Should a BH investor never use futures/options?

Post by Tanelorn »

t3chiman wrote:
Tanelorn wrote: With a short option, all you can make is 100% (if it ends up worthless), but that doesn't make up for losing 1000% if the short position moves against you...
The nightmare of unlimited losses from a short option position is possible only if your are writing naked calls. Writing covered call options (ie options on stocks you already own) is a very conservative strategy, approved for IRA accounts for instance. And what's wrong with making 100%?
Right - it's just an unlimited opportunity cost (lost gains), which is why they let you do it in your IRA. Still doesn't make it a good idea unless you know something special about the future volatility or lack of upside prospects for the stock.
bigred77
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Re: Should a BH investor never use futures/options?

Post by bigred77 »

Whats with all the derivatives talk on bogleheads recently??

A.) The vast majority of bogleheads have no need for this nor should they utilize options or futures.

B.) They can be useful as hedging instruments, usually for business purposes.

C.) They can be used to speculate, if you want to and understand what your doing.

D.) They play a part in Finance and have other uses for very sophisticated investors and institutional investors. These uses are most likely not at all relevent to bogleheads.
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Re: Should a BH investor never use futures/options?

Post by Johno »

691175002 wrote:Options as an investment are about the purest violation of the Bogle philosophy possible.

Recall that the decision to avoid active mutual funds is because on the whole it is a zero-sum game (or negative-sum after transaction costs). Outperformance of one manager must necessarily come at the cost of another manager since there are two sides to every trade.

Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative. Any dollar you make is a dollar someone else has directly lost.

You can argue that the diversification provided by options and other alternative (or even active) strategies can make them desirable on a risk-adjusted basis but then the discussion becomes more involved.
This is a basic misapplication of the idea of zero sum game as it applies to actively managed funds v index funds. Being long the S&P equity index futures is directly analogous to buying an S&P index ETF. The futures themselves are zero-sum. For every long position there's a short position. Every dollar in variation margin paid to/by the long when the index moves/up down is paid by/to the short. However zero-sum between long and short doesn't mean zero expected return for both long and short. The long position in the equity index futures has an expected return equal to the total return of S&P minus the implicit financing cost built into the futures price, plus the interest the long can get on the cash invested (which doesn't have to be used to actually buy the index ETF). That has to be true (within a very tight tolerance, relative to the funding cost of financial institutions) or else there would be free money on tap by buying/selling the futures and selling/buying the cash stock index.

So in that case, 'zero sum game' obviously does not mean zero return on each side. And it doesn't in general. And in fact going long the S&P equity index futures as an individual investor can beat holding an S&P index ETF because an individual unlike an institution can invest the excess cash in FDIC insured bank account rates, best of which tend to exceed the implicit financing rate reflected in the futures price. Depending on the prevailing bank rates, implied financing rates, commissions and bid-offer on rolling the futures positions as they expire, the net can come out to a effectively negative expense ratio up to few 10's of bps investing in the S&P via futures compared to the few bps ER of an S&P index ETF. It does involve work though, also secondary risks (chiefly, the credit risk for the % of the notional amount that must left as margin with the broker, as opposed to the larger % that can be kept in an FDIC insured account). Also, tax considerations might change the answer if the activity is being done in a taxable rather than tax deferred account. But in principal a continuous long (rolling) position in equity index futures is the same as buying a stock index fund.

Just because something is traded by 'professionals' doesn't mean the prices can't incorporate risk premia which can be harvested by any investor willing to take the risk. This is what you are also doing just investing in cash stocks or being long S&P futures. And the same, potentially, can be true for additional risk premia embedded in the implied volatility of equity index options. It is indeed more involved when it comes to options, but the point is that simple reference to 'zero sum game' or 'traded by professionals' doesn't necessarily tell us anything useful.
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Re: Should a BH investor never use futures/options?

Post by grabiner »

edge wrote:You can use them to hedge your exposure to your own company's stock.
Check with your compliance department; many corporations do not allow you to trade options on your own company's stock, and others may not allow you to take an adverse position such as buying a put, particularly if you are restricted from selling the stock.

However, options can make sense if the stock is not your own company's stock, and you have a good reason for not selling it. I believe I recommended an option on this forum, for an investor who was over 90 and had a large portion in one stock. If he sold the stock, he would lose 15% to taxes; if he waited to hold it until his death, his heirs could sell the stock with no tax consequences. By buying put options, he could insure against a large decline in the value of the stock, paying less for the insurance than the cost of selling.
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wshang
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Re: Should a BH investor never use futures/options?

Post by wshang »

Why would anyone ask this question on this forum? Of course you get these expected answers. It is indeed possible through a combination of option strategies to have a greater risk adjusted return. It takes work, homework, lots of it to understand these strategies. If you truly wish to invest time to understand, you might start by searching for delta neutral strategies.
This is some sales literature on BXM which some above have described as buy write:
http://www.cboe.com/micro/bxm/ibbotsonaug30final.pdf
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Re: Should a BH investor never use futures/options?

Post by JoMoney »

Many BH investors use futures/options without even knowing it.
Read your fund(s) prospectus and supplemental additional information. Almost all of the index funds can (and do) utilize stock index futures and or options to some limited extent to help manage the fund. They're explicitly not used to create leveraged positions, but can help the fund synthesize staying 100% invested in the underlying index while managing the constant fund inflows and outflows from investors.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Should a BH investor never use futures/options?

Post by stemikger »

acegolfer wrote:When should a long term buy and hold investor use futures/options?
"To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. ~ Warren Buffett

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Re: Should a BH investor never use futures/options?

Post by Waba »

acegolfer wrote:When should a long term buy and hold investor use futures/options?
Never, because you cant "hold" futures/options long term as they will expire. So they are not part of a buy and hold strategy.

An investor that wants to explore other (non-BH) strategies may have uses for them. There is a thread exploring a leveraged balanced fund strategy for example where they come to pass. They are also great vehicles for speculators. Some people believe that writing covered calls against their portfolio will increase their returns. None of these are strategies that Mr Bogle recommends.
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Re: Should a BH investor never use futures/options?

Post by robert88 »

Johno wrote:
691175002 wrote:Options as an investment are about the purest violation of the Bogle philosophy possible.

Recall that the decision to avoid active mutual funds is because on the whole it is a zero-sum game (or negative-sum after transaction costs). Outperformance of one manager must necessarily come at the cost of another manager since there are two sides to every trade.

Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative. Any dollar you make is a dollar someone else has directly lost.

You can argue that the diversification provided by options and other alternative (or even active) strategies can make them desirable on a risk-adjusted basis but then the discussion becomes more involved.
This is a basic misapplication of the idea of zero sum game as it applies to actively managed funds v index funds. Being long the S&P equity index futures is directly analogous to buying an S&P index ETF. The futures themselves are zero-sum. For every long position there's a short position. Every dollar in variation margin paid to/by the long when the index moves/up down is paid by/to the short. However zero-sum between long and short doesn't mean zero expected return for both long and short. The long position in the equity index futures has an expected return equal to the total return of S&P minus the implicit financing cost built into the futures price, plus the interest the long can get on the cash invested (which doesn't have to be used to actually buy the index ETF). That has to be true (within a very tight tolerance, relative to the funding cost of financial institutions) or else there would be free money on tap by buying/selling the futures and selling/buying the cash stock index.

.
Assuming all that is true and that I don't want to be leveraged, that still doesn't explain why I would want to own futures instead of the index outright. Why would I expect that the implicit financing costs of futures to be less than the returns on t-bills?
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Re: Should a BH investor never use futures/options?

Post by Johno »

robert88 wrote:
Johno wrote:
691175002 wrote:Options as an investment are about the purest violation of the Bogle philosophy possible.

Recall that the decision to avoid active mutual funds is because on the whole it is a zero-sum game (or negative-sum after transaction costs). Outperformance of one manager must necessarily come at the cost of another manager since there are two sides to every trade.
This is a basic misapplication of the idea of zero sum game as it applies to actively managed funds v index funds.
.
Assuming all that is true and that I don't want to be leveraged, that still doesn't explain why I would want to own futures instead of the index outright. Why would I expect that the implicit financing costs of futures to be less than the returns on t-bills?
Indeed it is all true. :D You wouldn't expect the implicit financing cost embedded in futures prices to be less than the corresponding T-bill rate, and it isn't. However it does tend to be significantly below the best rates on FDIC insured savings accounts. T-bill rates are hardly anything, implied financing rates on S&P index futures .4-.6% lately, but best bank account rates around 1%. Institutions can't access those deposit rates, so can't arbitrage that difference away.
http://www.cmegroup.com/trading/equity- ... /main.html
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Re: Should a BH investor never use futures/options?

Post by madbrain »

Tanelorn wrote:Still doesn't make it a good idea unless you know something special about the future volatility or lack of upside prospects for the stock.
In which case, why would you own the stock in the first place ?
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Re: Should a BH investor never use futures/options?

Post by 26USC »

You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
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Re: Should a BH investor never use futures/options?

Post by madbrain »

26USC wrote:You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
Assuming these short puts are cash-covered, this strategy does not necessarily outperform just putting that cash in the index, though.
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Re: Should a BH investor never use futures/options?

Post by ncole1 »

In the money call options can provide leveraged ownership of the asset (sort of). Often it is the cheapest "loan", so if you can convert your shares to the equivalent options and pull cash out to pay down a 4% mortgage, in theory you'll come out ahead with the same risk level.
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Re: Should a BH investor never use futures/options?

Post by wshang »

madbrain wrote:
26USC wrote:You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
Assuming these short puts are cash-covered, this strategy does not necessarily outperform just putting that cash in the index, though.
Just for the sake of being contrarian, take a look here:
http://papers.ssrn.com/sol3/papers.cfm? ... id=1827363
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Re: Should a BH investor never use futures/options?

Post by madbrain »

wshang wrote:
madbrain wrote:
26USC wrote:You can sell out of the money puts on SPY and get paid to rebalance when markets fall.
Assuming these short puts are cash-covered, this strategy does not necessarily outperform just putting that cash in the index, though.
Just for the sake of being contrarian, take a look here:
http://papers.ssrn.com/sol3/papers.cfm? ... id=1827363
Thank you - I downloaded the paper, but I'm afraid it went right over my head. It may well have merit - I can't say - but it sure seems awfully complicated.
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Re: Should a BH investor never use futures/options?

Post by TradingPlaces »

Beliavsky wrote:
acegolfer wrote:When should a long term buy and hold investor use futures/options?
You can

(1) replicate Treasury bond positions in a tax-advantaged manner through Treasury bond futures.
(2) hedge currency risk in international stocks and bonds through currency futures
(3) get commodities exposure by purchasing commodity futures and rolling them
(4) rebalance a portfolio to desired allocations through stock and bond futures rather than selling assets with capital gains

Note that I used the word "can", not "should". I don't currently do any of these things. Unlike passive "cash" strategies, even passive futures strategies require ongoing activity, since contracts expire.
Excellent post!

I can add one more:

- use treasury futures to get stock / bond allocation that has more than 100% notional exposure, but the same dollar risk as, say 50%/50% stock bond portfolio,

- use treasury futures to get leveraged exposure at the juiciest part of the yield curve. Pick that contract which has the highest expected Sharpe, and take as much dollar risk as you would otherwise do.
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Re: Should a BH investor never use futures/options?

Post by TradingPlaces »

691175002 wrote: Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative. Any dollar you make is a dollar someone else has directly lost.
This is not entirely true.

Price of volatility is the implied volatility in the option.
Implied volatility is consistently priced higher than FUTURE realized volatility.

Thus, systematically selling options USED to pay off handsomely.

I expect that this strategy will pay off in the future as well, just not as handsomely.

Notice that selling volatility does not mean selling naked options.
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Re: Should a BH investor never use futures/options?

Post by skepticalobserver »

As to using futures as a hedge be advised that:

there are transaction costs (commissions) for contract trades;

a futures contract is for a finite period so you must continually purchase new contacts (rolling over) to maintain the hedge;

futures contracts are highly leveraged, volatile and from time to time may not track the cash position (basis risk). Since futures contracts are marked-to-market intraday a significant widening of basis may require additional capital pursuant to a margin call;

creating a hedge is complicated and thus a knowledgeable broker is essential. Retail clients may find it difficult to find one; and,

hedging tends to be cost effective for large cash positions.
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Re: Should a BH investor never use futures/options?

Post by Johno »

skepticalobserver wrote:As to using futures as a hedge be advised that:
1. there are transaction costs (commissions) for contract trades;
2. a futures contract is for a finite period so you must continually purchase new contacts (rolling over) to maintain the hedge;
3. futures contracts are highly leveraged, volatile and from time to time may not track the cash position (basis risk). Since futures contracts are marked-to-market intraday a significant widening of basis may require additional capital pursuant to a margin call;
4. creating a hedge is complicated and thus a knowledgeable broker is essential. Retail clients may find it difficult to find one; and,
5. hedging tends to be cost effective for large cash positions.
Lets' quantify those points, assuming S&P 'emini' index futures, ticker ES, with the basic strategy of being continuously long the contract rather than buy underlying:
1. $2-$3 commission per trade at best brokers, the smaller part of the likely total transactions costs,
2. Quarterly contracts, and higher bid-offer spread in longer dated contracts generally means it's most economic just hold the front contract and roll the position 4 times a year. Thus, 8 trades (buy/sell each of the 4 quarterly contracts) per year. The first two contracts generally trade on a .25 bid to offer near expiry of the closer one, ie .125 bid-mid. So if selling on the bid and buying on the offer, at $50/tick, it's 8*(.125*50+3) bid offer and commission, $53 v notional amount at today's price ~2050*50=$102,500, if so ~5bps synthetic 'expense ratio'. It's often possible to get done on the same side of the market on both trades (hit the bid after getting hit on the bid yourself, lift the offer after getting lifted on the offer yourself, if market hasn't moved in that instant) though it's also possible that the market moves unfavorably between the two trades. There would be certain obvious pitfalls to avoid (trying to do it during a scheduled economic release, etc) and one could 'diversify' by rolling the position in pieces if larger than one contract. Anyway a different average bid-offer loss might be assumed but .125 is reasonable IME.
3. Basis shift in liquid contracts like ES would virtually never be significant wrt margin amount. In terms of 'synthetic ER' though, it would enter in insofar as the *relative* basis the between front and next contracts wobbles around slightly. IOW if the spread between front and second contract mid-point to mid-point is 7 ticks, you do the roll trade there successfully at 0 net bid-offer, but then the spread moves to 6.75 or 7.25 the cost was really .25 or -.25. The implied financing cost is really just another way of saying 'basis' for equity index contract, so another way of expressing the risk is to say you might lock in an implied cost of 0.4% pa or 0.6% pa, looking at recent results (see link above), for a particular 3 month period, and thus get more or less arbitrage advantage by holding (most of the) the notional amount in a bank at a higher rate.
4. It's hard to see how a strategy could be much simpler in concept. However any strategy is probably not suitable or economic if an investor needs ongoing professional assistance to carry it out. And carrying it out oneself does require some effort and monitoring.
5. As mentioned, the notional equivalent of one ES contract is now around $102.5k. It's not suitable for unleveraged investment if that's a big % of total investment.
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Re: Should a BH investor never use futures/options?

Post by ShiftF5 »

Elbowman wrote:
691175002 wrote:Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative.
This is not mentioned enough! You are playing a negative-sum game (after costs) against professionals. That should be all you need to know to discard this idea.
Much like trading Individual stocks? :oops:
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Re: Should a BH investor never use futures/options?

Post by wshang »

ShiftF5 wrote:
Elbowman wrote:
691175002 wrote:Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative.
This is not mentioned enough! You are playing a negative-sum game (after costs) against professionals. That should be all you need to know to discard this idea.
Much like trading Individual stocks? :oops:
Right off, let me say I am not recommending doing this, but to say "never do . . . " is frankly foolish.

Say as part of your "Long Term BH Investing Plan," you wish to purchase 100 shares of SPY, which as of this moment is 205. ($20,500)

Instead of plopping your money down and buying it, you sell one May 15th, 2015 put naked, (strike price $205) but backed by the cash you had set aside for this purpose. You immediately get $410 of option premium deposited in your account. This is yours regardless of what happens subsequently.

49 days from now, three possibilities exist:
1) SPY > 209.1: You didn't make as much as possible; possible, but not too likely.
2) SPY < 201.9: You did worse than holding cash, but the actually better than just simply buying 100 shares of SPY by +$410 dollars.
3) Between 201.9 and 209.1: Super, not only a very likely outcome but most probable outcome. You made more than simply buying 100 shares of SPY. In fact, if SPY is anywhere less than 205, repeat this again and collect some more option premium. If you are more sophisticated, buy your put back and repeat until you get exercised, then sell covered calls, until you get exercised, repeat ad nauseum.

Options and futures are tools. If you don't feel comfortable using them, don't. In fact most investors on this website like KISS, but it would be entirely incorrect to say the Lazy Portfolio or the BH portfolio is the optimal portfolio for every investor.
Johno
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Re: Should a BH investor never use futures/options?

Post by Johno »

ShiftF5 wrote:
Elbowman wrote:
691175002 wrote:Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative.
This is not mentioned enough! You are playing a negative-sum game (after costs) against professionals. That should be all you need to know to discard this idea.
Much like trading Individual stocks? :oops:
That's another way to illustrate the strength and weakness of that point. Trading options on individual stocks is very much related and analogous to trading individual stocks. Also, trading options on indexes is very much like trading in indexes. However rule based strategies using options on indexes are not any more inherently like 'trading' (timing, 'go up go up!, go down go down!, technicals etc) indexes than buying and holding the index is. Buy and hold is a rules based strategy, just the simplest one. But so is eg. sell a naked at-the-money put on the index monthly, that's not really that much more complicated in concept and it's been a persistent anomaly that it's had significantly better risk/return ratio than holding the underlying on average over long periods (not always and no future gtee). 'Zero sum game' and 'professionals' isn't any more relevant to one of those rules based strategies than the other. There might be reasons that rules based options strategies don't work, either in general or for particular investors' situations, but the hand wave of 'zero sum'/ 'professionals' is not it.
rgs92
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Re: Should a BH investor never use futures/options?

Post by rgs92 »

It just seems to me that you are always ultimately depending on the market going in the direction you predict no matter how complicated you dress it up with insanely complicated option strategies.
There is just more or less leverage factored into the bet depending on the approach. And, anecdotally, every one of the numerous people I have known who has gotten into this has done worse (sometimes a lot worse) than a normal boglehead method.
Beliavsky
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Re: Should a BH investor never use futures/options?

Post by Beliavsky »

Johno wrote:2. Quarterly contracts, and higher bid-offer spread in longer dated contracts generally means it's most economic just hold the front contract and roll the position 4 times a year.
Are there any discount futures brokers that will roll futures for you according to some rule (for example, roll to next quarterly contract two weeks before expiration) if you so instruct them?
This could make the operation of passive strategies in futures as simple as with cash instruments such as mutual funds.

You can use currency futures to hedge currency risk in foreign stock and bond investments. Or you can trade in foreign stock and bond futures instead of mutual funds that do so to avoid the currency risk to begin with.
691175002
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Re: Should a BH investor never use futures/options?

Post by 691175002 »

ShiftF5 wrote:
Elbowman wrote:
691175002 wrote:Just like active management, options are a true zero-sum game, meaning the expected return of all parties after transaction costs is always negative.
This is not mentioned enough! You are playing a negative-sum game (after costs) against professionals. That should be all you need to know to discard this idea.
Much like trading Individual stocks? :oops:
Investing in stocks is not a zero sum game as the economy (and hence aggregate corporate earnings) will grow over time. Investing in individual stocks is a zero-sum game relative to the index as a whole.

As was pointed out, the same argument can be applied to derivatives such as futures, or even synthetic positions constructed using options. This is even true of active management, which does generate above zero returns as a group.

The difference is that the aforementioned strategies should not be compared to a return of zero, they should be compared to the cheapest method of accessing their source of returns (or risk premium) which will generally be the underlying or benchmark. Unless you have a compelling reason why it cannot be arbitraged (such as the FDIC/Futures strategy) it is difficult to imagine a strategy outperforming its opportunity cost after fees.

Some derivative strategies access risk premiums which are not available through other means, which is what a lot of people are bringing up here. That is true, but the complexity of such strategies probably puts it out of reach for retail investors. Options used for other purposes such as hedging or tax-efficiency can also add value.

The point isn't that derivatives are always bad investments, but I wouldn't recommend covered calls or similar to an investor who is unable to at least follow this thread.
Beliavsky
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Re: Should a BH investor never use futures/options?

Post by Beliavsky »

691175002 wrote:Investing in stocks is not a zero sum game as the economy (and hence aggregate corporate earnings) will grow over time. Investing in individual stocks is a zero-sum game relative to the index as a whole.

As was pointed out, the same argument can be applied to derivatives such as futures, or even synthetic positions constructed using options.
Usually when you buy stock you are buying it from someone else on the secondary market, and doing so does not provide more capital to the company, unlike an IPO. Buying stock is a risk transfer. So is buying an S&P 500 futures contract. Which way of taking equity risk is better depends on taxes and transaction costs.
scotthew
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Re: Should a BH investor never use futures/options?

Post by scotthew »

Not never. I would be proud of you if worked for a cruise line or airline and bought oil futures to hedge against future oil price fluctuations. :sharebeer
Clive
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Re: Should a BH investor never use futures/options?

Post by Clive »

ncole1 wrote:In the money call options can provide leveraged ownership of the asset (sort of). Often it is the cheapest "loan", so if you can convert your shares to the equivalent options and pull cash out to pay down a 4% mortgage, in theory you'll come out ahead with the same risk level.
Synthetic long stock (buy at money call, sell at money put) costs next to nothing to start http://www.theoptionsguide.com/syntheti ... stock.aspx and replicates holding the index/stock. Leaving you with all your money still in hand - EXCEPT that's mathematical. In practice you'll have spreads, costs and deposit requirements, have to cover margin calls - which may be same day actions being required, and for some options there are early exercise risks.

If some fat fingered trader accidentally trades one million shares at $1 instead of 1 share at $1,000,000 - the likes of which have actually occurred in the past, then the markets may briefly go wild, triggering all sorts of margin calls. Share prices might dive briefly and your provider might decide to close out your positions at those low prices - as the 'tried to contact you for margin requirements and you were unavailable or unable to meet the margin call' [especially as it could potentially be highly beneficial for them to do so], only to see a recovery later the same day.

There's increased counter-party/margin call risks and whilst there's apparent potential benefit 'in theory' more often those totally fade after costs, spreads and liquidity are considered. If that were not the case then investors would all opt to hold synthetic long stock positions instead of the actual stock (excepting if they particularly wanted voting rights - that in practice few care about).

That doesn't mean derivatives should never be used - but rather if they are used do so in awareness of the small print risks involved.
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Re: Should a BH investor never use futures/options?

Post by nisiprius »

One of John C. Bogle's books (and a very good one) is entitled "Clash of the Cultures: Investing versus Speculating." One of his maxims is "invest, don't speculate." One of the rationales for owning a cap-weighted index fund is to be on both sides of every speculative trade, so that speculative returns cancel out and you are left only with the actual investment returns from the operations of the businesses whose stock comprises the index.

I think the way to answer the question whether a buy-and-hold, or a Boglehead--I am not sure which is meant by BH--should use futures and options is to ask whether there is a way to use them that makes them obviously fall in the category of "investing, not speculating."

There is a continuum between investing and speculating--"Wall Street" provides ways of doing both--nothing is purely investing or purely speculating. There's no crime in speculating, and some people make lots of money in it. But it's not Boglehead investing.

From where I sit and what I know, futures and options appear to me to be waaaayyyyy out on the speculative end of the spectrum. Maybe not in all cases, maybe not for everybody.

There is a one simple reason why I personally do not use futures or options. My brokerage account does not allow it. In order to enable it in my account, I would need to sign my name to a legal paper that, to put it bluntly, in my case would be a big old pack of fibs. I would have to be putting my name on a formal document saying I am totally cool with unlimited loss, and so forth. I could not honestly sign my name to the application. I take signing legal documents seriously. In a novel by John D. Macdonald someone gets caught in some fine print and says "But you said signing it was just a formality." The personal replies, "Yes, that is what it is--a formal, binding, legal document."
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Re: Should a BH investor never use futures/options?

Post by madbrain »

nisiprius wrote: There is a one simple reason why I personally do not use futures or options. My brokerage account does not allow it. In order to enable it in my account, I would need to sign my name to a legal paper that, to put it bluntly, in my case would be a big old pack of fibs. I would have to be putting my name on a formal document saying I am totally cool with unlimited loss, and so forth. I could not honestly sign my name to the application. I take signing legal documents seriously.
I don't believe a level 1 option trading agreement requires you to be "totally cool with unlimited loss", as generally the kind of option trade that is allowed for level 1 don't have this type of risk profile, especially if you trade options in a cash account as opposed to a margin account.
Tanelorn
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Re: Should a BH investor never use futures/options?

Post by Tanelorn »

scotthew wrote:Not never. I would be proud of you if worked for a cruise line or airline and bought oil futures to hedge against future oil price fluctuations. :sharebeer
Or if you worked as an investment advisor charging AUM fees and shorted the market based on the average asset allocation of your clients. Would you really want your salary to be cut in half just because 2008 (or 2003, or 1987) happened again?
Johno
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Re: Should a BH investor never use futures/options?

Post by Johno »

Clive wrote:
ncole1 wrote:In the money call options can provide leveraged ownership of the asset (sort of). Often it is the cheapest "loan", so if you can convert your shares to the equivalent options and pull cash out to pay down a 4% mortgage, in theory you'll come out ahead with the same risk level.
If some fat fingered trader accidentally trades one million shares at $1 instead of 1 share at $1,000,000 - the likes of which have actually occurred in the past, then the markets may briefly go wild, triggering all sorts of margin calls. Share prices might dive briefly and your provider might decide to close out your positions at those low prices - as the 'tried to contact you for margin requirements and you were unavailable or unable to meet the margin call' [especially as it could potentially be highly beneficial for them to do so], only to see a recovery later the same day.

There's increased counter-party/margin call risks and whilst there's apparent potential benefit 'in theory' more often those totally fade after costs, spreads and liquidity are considered. If that were not the case then investors would all opt to hold synthetic long stock positions instead of the actual stock (excepting if they particularly wanted voting rights - that in practice few care about).
It's generally cheaper and simpler to take synthetic long position via equity index futures than options on underlying (ETF etc). The other advantage relative to the point you made is that the daily movement limit in the (S&P emini, ES) contract is 20%, after which it stops trading for the day and you have a day to put more margin in the account before it starts trading the next day. Note, that's not any kind of price floor: the contract can open the next day down another 20% and close again immediately, and etc down to zero. But it does allow the investor to quantify the maximum daily margin required, assuming they can top it up from another source with a day's notice.

Otherwise the 'if this was a good idea everyone would do it, so it must not be' argument doesn't hold water for stuff that applies to individual investors. The cost of financing other than via futures varies by individual not to mention individuals v institutions. And there are barriers to doing it that aren't actual 'catches' per se but stuff you just have to do (roll trades, monitoring) which you wouldn't have to just holding underlying. But again it's investor-specific how important that is. The other factor in financing cost is point on the yield curve. You wouldn't necessarily want to fund at a 3 month rate just because it's lower in absolute terms than an ~18yr (30yr mortgage average life) rate, of course. Tax also enters that equation as mortgage is necessarily 'in taxable', futures strategy works better in tax deferred.

Currently the futures implied financing rate isn't compelling v a mortgage if assuming a significant tax benefit for mortgage, but futures strategy best done in IRA. Recent avg futures implied rate is order of LIBOR+.25%. Best current 30yr mortgage rate ~3.75%, even say 2.62% after tax at a 30% tax rate, ~LIBOR+.42% (ie ~42 over the interpolated LIBOR swap curve in 18yr). So that's pretty close, and there's also a call option in mortgage. OTOH while best rate for margin borrowing (against cash ETF positions, say) is much higher than the futures implied rate at Fed Funds+110 (at Interactive Brokers for $500k), that's also deductible so can be compared to 3.75% pre tax mortgage rate, ~LIBOR+155 (Fed Funds is a little below LIBOR). Thus it might make sense 'at the margin' (no pun intended) to slightly* leverage stock holdings and have less mortgage. Although, one would first want to consider whether a bond allocation should be shrunk as a way to reduce mortgage, and various other factors wrt mortgage (is it recourse or not? etc) also enter in. But it's not something to be rejected out of hand as 'can't be of benefit or else everyone would be doing it already'.

*IB has a dynamic margin calculation but comes to ballpark of 75% margin debt allowed rather than the traditional 50%. If one borrows say 25-30% the probability of a margin call is quite low.
skepticalobserver
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Re: Should a BH investor never use futures/options?

Post by skepticalobserver »

Johno:

When using futures to hedge a cash security position this usually means shorting the appropriate futures contract. The basis risk I was referring to is the widening of the spread between the cash position, which serves as margin, and the futures. When the market flash crashes (or really crashes) the spread gets way out of whack, bidders disappear, stop loss orders are meaningless and your broker deploys a couple of oversized guys to find you for more margin. From what I’ve observed, hedging requires vigilance.

Remember “portfolio insurance?” It was another name for hedging and in 1987 it hedged a lot of traders into bankruptcy.

I would recommend hedging if it’s done with other people’s money—and you take a fee.
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Re: Should a BH investor never use futures/options?

Post by itstoomuch »

Most of us, if not everybody, Use some type of option in our daily lives.
Life insurance, auto insurance, FDIC deposits, Treasuries, Mortgages. Pensions, SS
Ironically the asset that BH hold don't have an option -Indexes.
:oops:
Rev012718; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax TBT%. Early SS. FundRatio (FR) >1.1 67/70yo
Dave55
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Re: Should a BH investor never use futures/options?

Post by Dave55 »

I was a runner and phone clerk on the floor of the New York Mercantile Exchange and then graduated to a Futures Broker for institutional petroleum clients back in the 80's. Futures are a highly speculative instrument, one in which you can lose more money than you "bet". In my opinion, any investor who did not have an institutional or professional background in futures trading/markets should avoid them. And some of those folks should avoid them too! They are a 12 on the 1-10 risk spectrum, with 10 being highest risk.
As for options, my answer would be most of the population has very little to no knowledge about them, so why take the risk, complicate matters and add costs to the investing process?
I do not use either, nor do I use managed futures funds.

Dave
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