Hedged buy strategies can be useful in generating profits in stable markets and in some scenarios they can offer higher returns with lower risk than their underlying investments. In this article, you will learn how to use leverage to further increase capital efficiency and potential profitability.
Three methods of implementing such a strategy involve the use of different types of titles:
Although all of these methods serve the same purpose, the mechanisms are very different and each is better suited than the others to the needs of a particular type of investor.
Covered call returns
Hedged buy strategies combine a long position with a short call option in the same security. The combination of the two positions can often result in higher returns and lower volatility than the underlying index itself.
For example, in a flat or declining market, receiving the covered purchase premium may reduce the effect of a negative return or even make it positive. And when the market is rising, the returns of the covered buy strategy will generally be lower than the underlying index, but will remain positive. However, covered buying strategies are not always as secure as they seem. Not only does the investor remain exposed to market risk but also to the risk that over long periods the accumulated premiums will not be sufficient to cover losses. This situation can occur when volatility remains low for a long time and then suddenly rises.
Leverage investing involves investing with borrowed money in order to increase returns. The lower volatility of the returns of hedged buy strategies can make them a good basis for a leveraged investment strategy. For example, if a covered buy strategy should provide a 9% return, the principal can be borrowed at 5% and the investor can maintain a leverage ratio of 2 times ($ 2 of assets for every $ 1 equity); a return of 13% would then be expected (2 Ã 9% – 1 Ã 5% = 13%). And if the annualized volatility of the underlying hedged buy strategy is 10%, then the volatility of the 2 times the leveraged investment would be double that amount.
Of course, applying leverage only adds value when the returns on the underlying investments are significantly higher than the cost of the money borrowed. If the returns from a covered buy strategy are only 1% or 2% higher, then applying 2 times leverage will only contribute 1% or 2% to the return but would significantly increase the risk.
Calls covered in margin accounts
Margin accounts allow investors to buy securities with borrowed money, and if an investor has both margin and options available in the same account, a leveraged hedged buy strategy can be used. implemented by buying a stock or ETF on margin and then selling monthly covered calls. However, there are potential pitfalls. First, margin interest rates can vary widely. One broker may be willing to lend money at 5.5% while another charges 9.5%. As noted above, higher interest rates will drastically reduce profitability.
Second, any investor who uses the broker’s margin should manage their risk carefully, as there is always the possibility that a fall in the value of the underlying security could trigger a margin call and a forced sale. Margin calls occur when equity falls to 30-35% of the account’s value, which equates to a maximum leverage ratio of about 3.0 times. (Note: margin = 100 / leverage).
While most brokerage accounts allow investors to buy securities with a margin of 50%, which equates to a leverage ratio of 2.0, at this point it would only take a loss of about 25% to trigger a margin call. To avoid this danger, most investors would opt for lower leverage ratios; thus, the practical limit may be only 1.6 or 1.5 times, as at this level an investor could suffer a loss of 40-50% before receiving a margin call.
Call options covered with index futures
A futures contract provides the ability to buy a security at a specified price in the future, and that price incorporates a cost of capital equal to the broker’s call rate minus the dividend yield.
Futures are securities that are primarily designed for institutional investors but are increasingly becoming available to retail investors.
Since a futures contract is a long leveraged investment with a favorable cost of capital, it can be used as the basis of a covered buy strategy. The investor buys an index futures contract and then sells the equivalent number of monthly call option contracts on the same index. The nature of the transaction allows the broker to use long futures contracts as security for covered calls.
The mechanics of buying and holding a futures contract, however, are very different from holding stocks in a retail brokerage account. Instead of keeping equity in an account, a cash account is held, serving as security for the future of the index, and gains and losses are settled each market day.
The advantage is a higher leverage ratio, often up to 20 times for large indices, which creates tremendous capital efficiency. However, it is the investor’s responsibility to ensure that they maintain sufficient margin to maintain their positions, especially in times of high market risk.
Because futures contracts are designed for institutional investors, the dollar amounts associated with them are high. For example, if the S&P 500 index is trading at 1,400 and a futures contract on the index is 250 times the value of the index, then each contract equates to a leveraged investment of 350,000 $. For some indices, including the S&P 500 and the Nasdaq, mini-contracts are available at smaller sizes.
LEAPS covered calls
Another option is to use a LEAPS call option as security for the covered call. A LEAPS option is an option with an expiration date greater than nine months. The LEAPS call is bought on the underlying security, and the short calls are sold monthly and redeemed immediately before their expiration date. At this point, the next monthly sale is initiated and the process repeats until the LEAPS position expires.
The cost of the LEAPS option is, like any option, determined by:
- intrinsic value
- the interest rate
- the time until its expiration date
- the estimated long-term volatility of the security
Even though LEAPS calls can be expensive, due to their high time value, the cost is usually lower than buying the underlying security on margin.
Since the investor’s goal is to minimize downtime, the LEAPS call option is typically bought deep in the money, which requires maintaining a certain cash margin in order to maintain the call option. position. For example, if the S&P 500 ETF trades at $ 130, a two-year LEAPS call option with a strike price of $ 100 would be purchased and $ 30 cash margin held, then a call from a month sold with a strike price of $ 130, ie at the money.
By selling the LEAPS call option on its expiration date, the investor can expect to capture the appreciation of the underlying security during the holding period (two years, in the example above) , less interest charges or cover charges. Nonetheless, any investor holding a LEAPS option should be aware that its value could fluctuate significantly from this estimate due to changes in volatility.
In addition, if during the month following the index suddenly gains $ 15, the short call option will have to be redeemed before its expiration date so that another can be written. In addition, the cash margin requirements will also increase by $ 15. The unpredictable timing of cash flows can make it difficult to implement a hedged buy strategy with LEAPS, especially in volatile markets.
The bottom line
Leveraged hedged buy strategies can be used to earn profits from an investment if two conditions are met:
- The level of implied volatility taken into account in call options must be sufficient to account for potential losses.
- The returns of the underlying hedged buy strategy must be greater than the cost of borrowed capital.
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A retail investor can implement a leveraged hedged call strategy in a standard brokerage margin account, assuming the margin interest rate is low enough to generate profit and a low leverage ratio is maintained to avoid margin calls. For institutional investors, futures are the preferred choice because they offer higher leverage, low interest rates, and larger contracts.
LEAPS call options can also be used as the basis for a covered buy strategy and are widely available to retail and institutional investors. The difficulty of forecasting cash inflows and outflows from premiums, call option repurchases and changing cash margin requirements, however, makes it a relatively complex strategy, requiring a high degree of analysis and analysis. risk management.