Alternative to long positions: selling call spreads on leveraged bear and commodity ETFs

I've written pretty extensively (mostly on r/wallstreetbets) about leverage and my leveraged portfolio experiment but I wanted to write about an alternative that may seem a bit less risky to some.

With 2008 still (hopefully) in our minds, we should all be considering that in any given year we are exposing a broad-market equity position to a roughly ~40% draw-down. Personally, I'm far more concerned about drawdown than I am about "volatility". When considering my risk, I'm concerned with the amount of money I could lose in a given time frame, not the daily ups and downs. With that in mind, a long unlevered equity position has an expected max drawdown of 40% in a year (and potentially 60%+ on a multi-year horizon). On the other side, we consider ourselves pretty lucky to take a 10-15% gain in a given year on that same broad-market equity position. From a risk perspective, this is roughly akin to risking 40% to make ~15%, year over year. In dollars, for a hypothetical $10,000 investment, that means we're risking $4,000/yr to make $1,500/yr.

For the bulk of a long-term portfolio this is fine. After all, you can average in over a long time horizon, and continually buy shares in equities when they fall and so on. But what about at the margins? One way to go "long" an equity index is to short the inverse leveraged ETF. For instance, if you want to go long on the S&P, you can short SPXU (inverse 3x daily SPY), which will theoretically let you profit from a rising, flat, or only slowly declining market, as gains coming from the expense ratio of the fund and the decay of daily compounding that comes from a bearish fund add up to overwhelm any losses in SPY. But this is a) expensive b) hard to put in practice due to difficulty borrowing shares to short and c) still very risky, as you've got the unlimited risk of a short position.

Instead, I'm looking at selling call spreads on leveraged ETFs. This means looking at an index or sector that I'm bullish on (e.g. IWM, SPY, XLF, QQQ) and writing call spreads on the leveraged inverse. For instance, if you are bullish on SPY, you could write call spreads on SPXU with a good risk:reward profile. As an example, selling the 10/15 January 2019 call spread on SPXU would get you a $250 credit and a max loss of $250. That's a 100% RoC in 18 months on a position that is very unlikely to be a loser. On a shorter time horizon (e.g. January 2018), short call spreads on things like TZA, SQQQ, FAZ, etc all look appealing. For most of these trades, the natural decay of the leveraged bearish (or commodity) ETFs would make them successful even in a flat market.

A rapid correction and recovery like we saw in 2015 and 2016 would still result in profitable trades on the bearish equity call spreads. The only losing scenario for these trades is a full fledged bear market, but that would impart heavy losses on to a long unlevered stock position, too. If you think about a long equity position as a "risk 40 to make 15" trade, you'll see that many of these trades have much better risk:reward ratios than that. The trade off, of course, is time. If you are wrong on these trades in the 6-18 month time horizon, you lose 100%. But given that the RoC in most cases is north of 70%, you don't have to risk nearly as much capital to get the same expected return. It seems a reasonably safe strategy for a small portion of a portfolio, particularly if you are wary of adding to long or leveraged equities outright given current market conditions. That is, I could theoretically replicate good stock returns by continually rolling this strategy with ~10-15% of a portfolio while keeping the rest in cash (aka a barbell strategy). Or, alternatively, this can be implemented as a sort of "synthetic" leverage to an otherwise unlevered or modestly levered portfolio, for someone following the principles of life cycle investing.

I have a screenshot of my current position spreadsheet below and in most cases I built my target price assuming rates of decline quite a bit lower than historical averages (25-50% lower), giving me a wide safety margin. Essentially, it would take a pretty big trend change for these trades to not work out. As you can see from the sheet, a decent chunk of the trades are already trading below my B/E point (green in the "current" column), and most are within 10% (the yellow coloring in the "current" column). Some are opposing pairs (e.g. JNUG and JDST) where I'm hoping to capture the decay of both ETFs as their volatility exceeds the magnitude of any trend. Note that this is NOT true of equity ETFs – only of commodity ETFs.

Link to my post on wallstreetbets about short call spreads

Current positions spreadsheet

Submitted August 09, 2017 at 01:35PM by never_noob
via http://ift.tt/2uqjaTR

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