Enhanced Indexing Strategies E-Book

Tristan Yates

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 440

Veröffentlichungsjahr: 2008

Beschreibung

Leveraged index investments, including index futures, options, and ETFs, are one of the fastest growing products in finance, as both retail and institutional investors are attracted to their long-term returns and capital efficiency. With Enhanced Indexing Strategies, author Tristan Yates reveals how you can create and build high-performance indexing strategies using derivatives that can potentially generate much higher returns than conventional index investing. In addition, Enhanced Indexing Strategies introduces six innovative long-term indexing strategies using futures and options, each with its own advantages and applications.

Leseprobe

Table of Contents

Title Page

Copyright Page

Preface

CHAPTER BY CHAPTER

PERSONAL ENRICHMENT

CHAPTER 1 - Owning the Index

THE STORY OF INDEXING

INDEXING: STRATEGY OR PHILOSOPHY?

INDEX RISK AND REWARD

HIGH PERFORMANCE INDEXES

FORECASTING INDEX RETURNS

SUMMARY

CHAPTER 2 - Applying Leverage

LEVERAGED INVESTMENTS: CONSERVATION OF RISK

USING THE LEVERAGE RATIO

UNDERWATER INVESTMENTS

DEBT AND INTEREST EFFECTS

SOURCES OF LEVERAGE

MANAGING A LEVERAGED PORTFOLIO

SUMMARY

CHAPTER 3 - Indexing with Synthetics and Futures

ASSET ALLOCATION

INDEX PORTFOLIO RETURNS

HOLDING SYNTHETIC POSITIONS

TRANSACTION COSTS

EXPECTED RETURNS AND REINVESTMENT

ADDING PORTFOLIO VOLATILITY

RANDOM SCENARIOS WITH MONTE CARLO

MARGIN CALLS

SUBSTITUTING FUTURES

SUMMARY

CHAPTER 4 - Capturing Index Appreciation with Calls

INTUITIVE OPTION PRICING

CAPTURING APPRECIATION WITH OPTIONS

OPTION ANALYSIS

SUMMARY

CHAPTER 5 - Leveraged Covered Calls with Futures

COVERED CALLS AS A SOURCE OF INCOME

POSITION DETAILS

EXPECTED STRATEGY RETURNS

ANNUAL RETURN BACKTESTS

VIX MODIFICATIONS

ASSET ALLOCATION

ADDITIONAL ANALYSIS

SUMMARY

CHAPTER 6 - Rolling LEAPS Call Options Explained

UNDERSTANDING LEAPS CALLS

ROLLING LEAPS FORWARD

ROLL COST PREDICTION

ESTIMATING AVERAGE RETURNS

INVESTING CASH FLOW

CAPTURING APPRECIATION

ROLLING UP

SELECTING INDEXES AND STRIKE PRICES

MARKET DROPS AND VOLATILITY SPIKES

LEAPS COVERED CALLS

SUMMARY

CHAPTER 7 - Long-Term Returns Using Rolled LEAPS

STRIKE PRICE SELECTION

SECTOR PERFORMANCE: 1999 TO 2006

SECTOR PORTFOLIO RETURNS

REBALANCING

HIGHER PERFORMANCE PORTFOLIOS

REINVESTMENT ISSUES

COVERED CALLS AND MID-CAPS

COVERED CALLS WITH SECTORS

SUMMARY

CHAPTER 8 - Long and Short Profits with Call Spreads

UNDERSTANDING DEBIT SPREADS

BULL CALL SPREADS

CALL SPREADS AND APPRECIATION

SPREADS AND SKEWS

EARLY EXIT

DIAGONAL CALL SPREADS

LONG/SHORT PORTFOLIOS FROM DIAGONALS

EARLY EXIT AND THETA

CALENDAR CALL SPREADS

LEAPS CALENDAR CALLS AND EARLY EXITS

CYCLING INVESTMENT GAINS

INDEX REGIME CHANGE

SUMMARY

CHAPTER 9 - Cycling Earnings Using Spread Positions

SHORT OPTION SELECTION

LONG OPTION

CREATING THE DIAGONAL SPREAD

OPTION PORTFOLIO

CYCLING FRACTIONAL AND FIXED

FASTER REINVESTMENT

TRANSACTION AND SPREAD COSTS

FAST CYCLING WITH CALENDARS

VOLATILITY MODELING

WEEKLY VOLATILITY SIMULATION

WEEKLY STRATEGY RETURNS

SUMMARY

CHAPTER 10 - Practical Hedging with Put Spreads

ABOUT PUT OPTIONS

SELLING PUTS VERSUS COVERED CALLS

SELLER RISK IN PRICING

PROTECTING PORTFOLIOS

PUTS, FUTURES, AND LEVERAGE

DIVERSIFICATION AND CORRELATION

COLLARED PORTFOLIOS

BEAR PUT SPREADS AND SPEED BUMPS

BULL AND CALENDAR PUT SPREADS

CALENDAR PUT SPREAD

DEEP-IN-THE-MONEY CALENDARS AND DIAGONALS

ROLLING LEAPS PUTS

ROLLING LEAPS CALENDAR SPREAD

SUMMARY

CHAPTER 11 - LEAPS Puts and Three Ways to Profit

PORTFOLIO SAFETY NETS

EXPECTED RETURNS AND HEDGING ANALYSIS

CORRELATED INDEXES USING SIMTOOLS

CORRELATED PROTECTED PORTFOLIOS

LEAPS CALENDAR PUT SPREADS

LEAPS CALENDAR PUT PORTFOLIOS

HISTORICAL PERFORMANCE

PUT WRITING WITH LEAPS

SUMMARY

CHAPTER 12 - Managing the Leveraged Multistrategy Portfolio

THE QUESTION OF ALTERNATIVE ASSETS

PROSHARES ETF ANALYSIS

ASSET MANAGEMENT OVERVIEW

SUMMARY

FINAL WORDS

APPENDIX - List of Index ETFs and Futures

About the Author

Index

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.

For a list of available titles, visit our Web site at www.WileyFinance.com.

Copyright © 2009 by Tristan Yates. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:Yates, Tristan. Enhanced indexing strategies : utilizing futures and options to achieve higher performance / Tristan Yates. p. cm. - (Wiley trading series) Includes index.

eISBN : 978-0-470-46021-4

1. Index mutual funds. 2. Stock price indexes. 3. Investments. 4. Portfolio management. I. Title. HG4530.Y365 2009 332.64’5-dc22 2008019098.

Preface

What if we could borrow money at 5 percent and reinvest it at 10 percent annually for years or even decades? This simple idea proved to be the seed for an ambitious project, a book created to show investors how to use futures and options on index-linked securities to earn very high portfolio returns. After more than a year of writing and research, here is that book.

To achieve our goal, we start with the highest performing and most reliable investment available in the marketplace, the index fund. In the past several years, literally hundreds of index-related products have been introduced in the marketplace, most designed to capture a narrow slice of returns in the broad markets and provide investors with the capability to mix and match different funds in order to build custom portfolios.

Ironically, this wide variety of investment products creates a security selection problem that is very similar to the one that indexing was created to avoid. In this book, we show exactly why some indexes perform better than others and how to successfully combine products into portfolios that deliver better risk-adjusted returns than Standard & Poor’s 500 Index (S&P 500). These index portfolios are the basis of our leveraged portfolios.

The next step is to apply leverage, and the most cost-effective way to do this is by using derivatives such as futures and options. With these instruments, it is possible to not only borrow money to invest at a low rate of return, but also, when using options, to implement hedging strategies that help reduce the risk of catastrophic losses.

A key difference between this book and others on option trading is that here options positions are used to capture long-term pricing trends rather than short-term market movements. On average, the index rises 10 percent a year, but some years it gains 25 percent and in others it loses 25 percent, and the aim is to develop and present a variety of option strategies that can capture appreciation in volatile conditions across many years. Six chapters are devoted to implementing specific long-term strategies.

As a result, this book discusses some options strategies in depth but omits others that would be inappropriate to those goals. The focus is primarily on long calls and call spreads, LEAPS options, and hedging strategies. Previous exposure to options strategies is definitely helpful, but not required, but a solid understanding of investing and index funds is obligatory, and a facility with Excel is assumed.

CHAPTER BY CHAPTER

The first and introductory chapter in any book on indexing is usually quite tedious, as it presents material that we’ve already encountered in a dozen other similar books, forcing us to skip ahead to the point where we can find something new. Thankfully, for both the reader and the author, this book does not have a chapter like this.

Instead we start Chapter 1, “Owning the Index,” with the story of an ambitious project by the University of Chicago that could be considered the genesis of modern index investing. It goes on to discuss how both active and index investing can work in a semi-efficient market; whether there is momentum or mean reversion in the markets; how to interpret market cycles; why some indexes are designed for low volatility and others for high performance; how, exactly, the small-cap and value premiums deliver results; and what the potential factors could be for a four- or five-factor model. Every effort was made to ensure that the reader—including the reader who has studied the index for decades—will be treated to new material and different ways of looking at the index.

The second chapter, “Applying Leverage,” covers the use of leverage in investment portfolios. To many people, leverage is a dirty word, associated with excessive greed and devastating financial losses. But realistically, without leverage to provide purchasing power, the price of every asset in the marketplace would be lower. We begin the chapter with a defense of the practice, or at least an explanation, provided during one of the stock market’s most difficult periods by none other than Merton Miller, the Nobel Prize-winning economist.

The first concept covered in Chapter 2 is the leverage ratio, and portfolios are shown that both gain and lose value over time as a result of leverage. Special attention is given to underwater investments, which are investments in which the level of debt is greater than the value of the assets due to falling prices. Sources of portfolio leverage that can be applied to index investments are also introduced, including margin loans, futures contracts, and options. Because the most difficult but most important part of managing a leveraged portfolio is reinvesting and compounding gains, the chapter also examines three different types of reinvestment strategies, and also reviews rebalancing and dollar-cost-averaging techniques that incorporate leverage.

Chapter 3, “Indexing with Synthetics and Futures,” is the first strategy chapter of the book, and shows how to build a leveraged diversified index-based portfolio with synthetics, which are options positions that replicate a leveraged stock or index position. By holding options on four different indexes, an investor can earn annual returns of 15 percent with decreasing leverage, but with some initial risk of margin calls. Next, we show how to substitute futures to reduce the margin risk and ramp up the leverage to get higher returns.

Chapter 4, “Capturing Index Appreciation with Calls,” begins with an intuitive approach to options pricing that can help investors understand exactly why an option is priced at a certain level, and how to pair the right option with a specific strategy. Next, the Black-Scholes model is introduced and applied to a number of index call options in an effort to determine which ones are best at capturing appreciation and what returns can be expected.

A useful piece of analysis is found at the end of the chapter: a historical comparison is made between the closing level of the VIX and the volatility experienced during the next week, and during the next thirteen weeks. We show that the VIX is not a useful predictor of return, but is an important predictor of future volatility, with some caveats.

Chapter 5, another strategy chapter, builds a leveraged covered call portfolio using short options and long futures. Covered calls have a fascinating risk-reward relationship and can often provide risk-adjusted returns significantly higher than those of long-only portfolios, which makes them an excellent candidate for leverage.

At maximum leverage, the covered call portfolio is capable of losing more than its total investment, and the chapter focuses not only on leverage ratios and asset allocation, but also introduces a possible adjustment using the VIX and the research discussed above that can act as a market timing mechanism and reduce potential losses from the strategy.

Chapters 6 and 7 are related to a specific strategy, Rolling LEAPS Call Options. Chapter 6 shows how to use LEAPS call options to create a leveraged long-term position on the index by rolling the option over again and again for many years. During that time, the underlying asset appreciates and the roll forward costs decline, building large amounts of equity and multiyear annual returns in the 15 to 20 percent range.

Rolling LEAPS call options is one of the most predictable leveraged strategies, in that all of the cash outflows can be calculated to a relatively high degree of precision. This makes budgeting very easy and reduces much of the risk associated with reinvestment.

In Chapter 7, we model the Rolling LEAPS Call Option strategy during one of the market’s worst periods and see the results. Then, we use various rebalancing and reinvestment strategies in order to raise the level of return.

Chapter 8, “Long and Short Profits with Call Spreads,” explains how to combine long and short options to create profitable positions. We begin the discussion with one of the most popular spread positions, the bull call spread, and explain why it is profitable in theory but not in practice, because of the volatility skew, the effect of the bid-ask spread, and the difficulty of early exit.

Two other spread positions are introduced that have much more profit potential: the diagonal call spread and the calendar call spread. Each of these positions limits the risk, but can provide profits many times larger than the original cost of the position.

The chapter also introduces a new asset allocation concept in which funds are rapidly and repeatedly cycled through short-term investments, and suggests how to calculate the ideal asset allocation using the Kelly criterion, a gambling technique. This method has the potential to create extremely high payoffs over time, but would also experience large drawdowns at certain points.

In Chapter 9, “Cycling Earnings Using Spread Positions,” we apply the cycling technique to a diagonal call spread strategy using one-year call options, and then extend the strategy to a biweekly variation using front-month calls. These are extremely profitable strategies, but have a very wide distribution, in which some portfolios have doubled or tripled, but others have lost value. A relatively simple method is also presented to simulate weekly volatility in order to effectively model the short-term strategy.

Chapter 10, “Practical Hedging with Put Spreads,” and its strategy counterpart Chapter 11, “LEAPS Puts and Three Ways to Profit,” are two of the most important chapters in the book, as together they demonstrate how to prevent catastrophic portfolio losses. We show why simply buying put options is not cost-effective, and then introduce put spread strategies such as the collar and the speed bump that will provide similar portfolio protection at a much lower price.

Portfolio protection allows more aggressive investment, which can create higher returns, and Chapter 11 validates this concept using a highly leveraged index fund with a hedge in place that allows it to avoid catastrophic losses while paying a relatively small price in terms of performance. We show that over a ten-year period this portfolio is expected to grow to five times its initial value.

Chapters 10 and 11 also cover other profitable index-related strategies using put options, including holding calendar put spreads and using LEAPS as security for a put-writing strategy. Each of these strategies generates high returns, but also presents some challenges when it comes to reinvestment.

Chapter 12, “Managing the Leveraged Multistrategy Portfolio,” is the capstone chapter that explains how to combine the above concepts and strategies into a single investment portfolio. It begins by addressing the question of whether to index commodities in addition to equities, and then explains why one of the most well-known and widely used leveraged index funds in the marketplace, the ProShares Ultra S&P 500, has underperformed its underlying index, and what we can learn from this situation.

Finally, we emphasize that managing a leveraged investing portfolio is similar to managing any type of project or process, and requires setting objectives, carrying out associated tasks, and monitoring and measuring results. In the context of portfolio management, this requires selecting indexes and strategies and determining the level of exposure, calculating the expected returns and the possible range of returns, and then monitoring the portfolio to ensure that it is performing in accordance to projections.

And then, we encourage you to get started. Many investors, when presented with a variety of choices, suffer from “analysis paralysis” and end up deferring their investment indefinitely. These are often the kind of people who won’t buy when the index is up because they feel they have missed the gains, and then won’t buy when it’s down because they are concerned about more losses. But the data present a crystal-clear message: Every day that you are not invested in the index is a missed opportunity for profit.

PERSONAL ENRICHMENT

I would also like to offer one more lesson from my experience, which is that the study and practice of index investing is a path to enrichment. But I don’t mean only financial rewards, although of course those are substantial over time. The benefits go far beyond that.

Students of indexing have access to a wealth of information on the subject, ranging from introductory articles to papers by Nobel Prize-winning economists. They also have the benefit of pricing data sets that go back for decades and inexpensive computing resources that make examination of this data possible, assuming that one has the proper mathematical and statistical foundations.

The challenge is to put all of this together into practical and useful techniques and recommendations for investors. It is a never-ending task because every day new products are announced, new research is published, and the existing indexes add more data points to their history. The ongoing effort is a mental marathon that develops both intellectual curiosity and strong analytical capabilities in those who choose to pursue it.

What I have found is that as the study of indexing enriches the mind, the egalitarian nature of the discipline enriches the soul. Not only are the authorities in the field always willing to share valuable knowledge and data, but they also seem to share the same conviction, which is that everyone, everywhere, deserves the benefits of index investing, regardless of their starting level of wealth or financial knowledge.

The accumulated expertise that is being created in this field is leading to the creation of hundreds of billions, perhaps trillions, of dollars, and all of that wealth will have a profound effect on the lives of millions of individuals across all levels of society. I find it difficult to think of anything more exciting or uplifting, and am proud to be a part of this collective effort. I have no doubt that you will also find the study and practice extremely rewarding.

I should also mention that this book, and very likely my financial writing career, would not have been possible without the help of three editors who gave me early opportunities and exposure, and I would like to express my appreciation. Those editors are David Jackson at Seeking Alpha, Chad Langager at Investopedia, and David Bukey at Futures & Options Trader.

And lastly, I would like to thank the team at John Wiley & Sons. Wiley was the only publisher that I ever considered for this book, a decision that has been validated throughout this process again and again, and I thank them immensely for this opportunity and their efforts.

CHAPTER 1

Owning the Index

Is indexing a strategy or a philosophy? In this chapter we make the case that it’s a little of each, and tell the story of how fifty years ago a combination of advances in computing technology and research in risk management set the groundwork for a revolution in both the science of and attitudes toward investing.

While the financial industry was initially slow to embrace the practice of indexing, the brightest minds in financial academia have been researching the subject for decades, and here we present a collection of some of the most interesting and practical findings, including the results of one ground-breaking paper published by Eugene Fama and Kenneth French in 1964, and another by the same team in 2007.

One of the most researched topics in the long-term behavior of indexes is whether there are patterns or trends in the pricing of indexes that can be identified and possibly exploited. Many investors have beliefs and assumptions that are based upon little hard evidence, and in this chapter we present the most up-to-date research in this area.