You can start by rereading this newly assembles thread.
First, you don’t actually “buy” them, you open a position at a certain reference price, which is the price at which your trade was executed.
Second, futures live in a separate futures account. A certain amount of cash, like 10% of the nominal value of the futures contract, will be transferred from your normal (securities) account to the futures account.
Every day at the market close, the difference between the nominal close value of the contract and the previous reference value is added or deducted from the futures account. First day it is close minus your opening price, afterward it is today’s close minus yesterday’s close.
Futures account can’t have a negative cash balance. The cash is always transferred from the securities account when needed. You may get a negative cash position in your securities account, meaning that you are borrowing on a margin. With everything that is implied.
If the futures’ positions are not very big comparing to the value of securities you hold, no problem. You borrow cash on margin to finance losses on futures, potentially the margin for futures as well.
Note that in this case you pay an interest for borrowing cash twice: there are implied financing costs of the full nominal amount embedded in the futures contracts AND you pay the interest to borrow missing cash from IB. You might also earn interest on excess cash in the securities account, though, but less than market rates embedded in the future, of course.
Personally I wanted to increase the leverage without taking too much risk of wiping out my securities positions and without having to rebalance positions often. So I ended up with UPRO, actually.
I’m still torn as ever as to how I should implement leverage in my portfolio. I’ll use your comment as a cue to dump what I have gathered till now.
Everybody, feel free to take a dive and criticize or ask questions.
Instruments
Leveraged ETFs
Advantages:
Can’t blow up your account, only itself
Smaller denomination than futures or options.
Can be tax-efficient by netting gross dividends (without WHT) against expenses.
Probably better protections against flash crashes (they are professionals with lawyers and they have customers with lawyers)
Probably no chance to be classified as professional security trader by the taxman.
Abundant data for backtests.
Disadvantages:
Can only leverage itself, and only at a low factor (3x for UPRO).
If I want 1.5x leverage, half (75%) will be plain S&P 500 in UPRO. If you want international exposure you can substitute some of it for leveraged EAFE or EM ETFs, but they are even worse than UPRO in implementation.
Or you could buy more standard funds, filling about an additional 50%. Now you only have 25% for whatever other things you want to put in your portfolio.
Will be liquidated at the lowest point for high daily market drops.
Theoretically a 3x should withstand up until -33.3…%, but who knows what the fine print says, and what their counterparty thinks it says. If they have margin requirements this number is quite a bit lower (e.g., -25% for 25% minimum margin) and dangerously close to realistic intraday drops.
Although, UPRO specifically should benefit from S&P 500 circuit breakers at -20%.
The implementation is not transparent, but expensive.
If we benchmark it to S&P 500 Total Return with daily rebalance gross of fees (testfol.io link), we get an annual drag of about 2.3%.
If we allow for (2x) 0.5% markup against long futures positions, we still pay 1.3% for their implementation.
Disregarding that weekly rebalancing gives consistently higher returns for less drawdown, we can look at the average index price change of about 0.75% from trading day to trading day. This will result in a rebalancing of about 4.5% each time. There are about 250 such intervals each year, but let’s be generous and assume daily (365). This gives a yearly rebalancing volume of about 16.5 times the net assets. But spread for ES futures is one tick at 0.25 USD. The S&P 500 is at about 5550 USD, so crossing the spread is about 0.0045%. Fees are still orders of magnitude smaller. We arrive at 0.07% trading costs for the full volume per year. Which moves the ETF cost to 1.23%.
So, 1.23% per year on top of everything relevant disappears into the void.
Margin loan
Advantages:
Buy whatever you want.
Buy and hold leverage is restricted to 2x under Reg T and about 10x on portfolio margin. Those are maximums with margin calls / auto-liquidation on breach.
Smaller denomination than futures or options.
Subtract margin interest from taxable income. But you also can’t get (WHT) tax credit for the portion you don’t pay Swiss taxes on.
Easy to calculate and understand costs and markups.
Abundant data for backtests.
Disadvantages:
Can blow up your account
Cheap margin interest markups also imply auto-liquidations (e.g, IBKR gives a maximum 1.5% markup). There are brokers which will normally (at their discretion) call you and give you a day to fix your margin deficiency, but they want more interest.
Flash crashes and auto-liquidation can mean your otherwise perfectly fine portfolio gets sold at negative net value. You now have nothing and owe the broker. I’m almost certain you signed somewhere that you are A-OK with this.
Different from futures any security can trigger this.
Concentrated and illiquid portfolios are at high risk.
Mutual funds can be used for margin. But since they set their own price, they don’t have flash crashes. Also they can’t be auto-liquidated instantly, but it will take a day. And since flash crashes aren’t real prices, you will get a normal price if you are forced to redeem.
Reclassification of a security to being not eligible to use for margin can have similar effects to a flash crash. Though, your broker would probably have a harder time justifying themselves, if they don’t give you time to act.
Using significant credit is one of the main criteria for classification as professional security trader. Interest at or higher than total income is a big no-no.
Using margin credit allows your broker to do security lending with your shares. You will get PILs instead of dividends on lent shares. Having tax free dividends converted to PILs can hurt. At least for US securities that means full WHT and possibly no Swiss tax credit on that. For non-US securities it seems it could be beneficial, since those PILs are paid gross (bypassing non-US and US WHT). But reliable information is hard to come by.
Like margin loan, buy whatever you want at similar maximum leverage.
Competitive market rates for interest rate markups. But probably only at wide boxes. Narrow boxes might get drag by option spreads. Wider boxes also mean bigger denominations. But maybe visible bid-asks of the individual legs are different from actual demand for a whole box-spread.
Abundant stock, bond, ETF data for backtests.
Disadvantages:
The box-spread interest is capital loss and can’t be deducted from your income. As consolation you get full tax credit on WHT.
Like margin loan, can blow up your account.
But additionally, the box-spread has a margin requirement of cost to close (under Reg T, Portfolio margin probably similar). If option spreads widen, you will need enough capital for each leg (4x).
If you are liquidated, and only one leg of the box-spread is liquidated, the situation can spiral out of control quickly. You are now naked short on very high leverage.
Hits two of three main criteria for classification as professional security trader.
Using significant credit. Interest at or higher than total income is a big no-no.
Using derivatives. Big volumes are problematic, but for lower leverage levels without much buying and selling that should probably be ok.
Like margin loan, allows security lending, because gross account value is bigger than net account value.
Understanding and calculating the box-spread is not trivial but also not hard. But there is a high potential for liquidating your account by entering the trade incorrectly.
Options data for backtests locked behind data vendors.
Futures
Advantages:
Tax free
Mostly very tight and liquid spreads. Reasonable markups priced in by the market.
Leverage about 10x and more. Those are maximums with margin calls / auto-liquidation on breach.
Trade commodities & go short conveniently (DIY trend following)
Disadvantages:
Can blow up your account
Mostly similar problems as margin loans, but more resistant to flash crashes and other shenanigans.
If you enter a futures contract, you only nominally have a position, you don’t owe anything until the futures contract moves against you. If you don’t owe anything, then your other securities having a value of zero for some moments doesn’t matter.
If you already took some margin credit on your securities account to put up maintenance margin on your futures account, you have the same problems as above. If the futures price (or even the bid) flash crashes this probably also happens (margin credit on security account to futures account). Also futures can potentially go negative (see oil futures).
There is a limited number of futures markets. They mainly target important indexes (e.g., S&P 500).
The denominations are rather large (nominal 10’000 USD would be a very small one, 100’000 USD would be more common).
Using derivatives is one of the main criteria for classification as professional security trader. Big volumes are problematic, but for lower leverage levels without much buying and selling that should probably be ok.
Every day cash flows into or out of the contract. This will be annoying to manage and account for. It is also unclear what the taxman considers as volume.
Futures are harder to understand. But understanding cost of carry does the trick.
Data for backtests is sparse.
Long call options
Advantages:
Tax free
Can not blow up your account (but can, if you exercise them and the underlying price moves against you too much till settlement).
Price drops hurt less, but price increases benefit you more (delta is lower at low prices and higher at high prices). Rising volatility will increase the value of the option.
It could be attractive to buy ITM options and roll them down if the underlying decreases to the strike price. Selling will not only sell the maximum time value and buy for less time value, but also increase the delta again, after you profited from a lowering delta during the falling price.
There are index options, futures options, and options on other securities like stocks and bonds. So there are options for nearly everything, but liquidity quickly decreases for less mainstream titles.
Disadvantages:
Can have significant spreads.
Has 10x or higher leverage at strike, but this is mostly decaying time value. Reducing time value decay reduces leverage (or makes it unlikely to get anything by going OTM)
The limited downside of long calls is paid by time value decay.
This is large enough to have a significant impact on the profitability of leverage and can make it not profitable.
You can make this smaller by buying deeper ITM (but leverage decreases). Or buy with expiration further away in the future (but spreads increase). Or sell short a put option to get a synthetic long position (but this can blow up your account and margin requirements for naked short options are not nice).
The denomination of nominal underlying value is rather large. For stocks it is 100x and for indexes it is in the same range as futures.
Using derivatives is one of the main criteria for classification as professional security trader. Big volumes are problematic, but for lower leverage levels without much buying and selling that should probably be ok.
Buying and selling options can quickly generate a lot of volume.
Very hard to understand. The Black-Scholes is an ok (and already plenty difficult) model, but apparently a less accurate one amongst many.
Data for backtests locked behind data vendors.
CFDs
I don’t know too much about these, but I often hear they are a bad deal. Your counterparty is normally your broker only. They charge high rates, fees, spreads. Everything is fully taxable as income. But you can probably have arbitrary small denominations depending on your broker.
My current evaluation
If ITM LEAP index options could be bought at mid market, they would seem to be the best. I don’t know if the visible spread is real or if others would bite at around mid market. Also SPX (S&P 500 price index) options have tighter spreads, but mid market became quite a bit higher than interest and dividend rates would suggest. High, even considering a reasonable markup present in mid market of other options.
I think index futures are still the best instrument. They are cheap, and quite resistant to flash crashes on a portfolio level.
Margin capital via box-spreads is another very interesting option.
Then you also dont have a problem crediting your withholding taxes.
No “interest” deduction though, but interest you get here is very competitive anyway.
You can for example borrow CHF with SMI options for <1.5% for a year currently.
I think it‘s the most interesting option for me currently, as it‘s the second most flexible after margin.
Just need to read up on the intricacies a bit more.
The tax freenes of futures however is interesting, but I doubt the tax office likes it if your account just consists of futures and you never pay tax.
Ah yes, I know about that one, but forgot. I’ll add a section.
Disregarding tax, it would be inefficient to hold the net part of your portfolio with leveraged instruments. You pay markups on both sides (getting less from cash collateral, paying more than interest rates on the instrument). With tax it is more even. It would probably depend on the asset class (high yield bonds vs. growth stocks) and canton (Jura vs. Zug).
Very nice writeup. I specifically like how you call out whether something can blow up your account or not.
When I did my own due diligence I decided that I’d only play with leveraged ETFs - exactly because as you say, I reached the conclusion that this is the only “exotic” that can’t blow up my account, I have a severe allergy to debt! I decided to avoid all other exotic options, including anything but the most vanilla of options (covered calls, cash-secured puts - haven’t actually done anything with options though because I don’t have enough liquidity to make anything meaningful out of it for the effort/worry).
My understanding of CFDs when doing my first reading is that they should be avoided as they’re really just an agreement that the broker will give you the Difference of the price between two time points, you don’t actually own anything so if the broker goes tits up so does your investment. My understanding is that CFDs are more for circumventing legal restrictions to investing in specific instruments/products, not something I want to be involved in.
On the tax advantage of margin loan vs. futures, what I see is that you deduct interest rate from taxes, but you are taxed on dividends. So margin loan ends up being advantageous if the current market interest rate is greater than dividends + (1-r)/r * markup where r is your marginal tax rate and markup is what the broker charges you for the loan (1.5% for ibrk pro). Is my math correct?
Another sanity-check question. If I hold $N worth of ETFs that are rather correlated with the market (and no excess cash), then in order to withstand an X% drop my account should hold no more than k micro e-minis, where k \le \frac{(1-X) N}{2 X V} where V is 5 times the index value ($25k or something like that right now). So if X is 66% and N is $100k, that would be no more than 1 of these micros. Is it correct?
Sorry I can’t grasp your formulas (maybe it’s too early ). Can you provide a hint of their derivations?
Wrong.
4 S&P 500 micro mini blabla is around 100k USD, so you are at the leverage of 2x. During the drawdown, the value of your securities decreases by approximately the same factor. So you are already at 0 with a -50% drawdown. With the standard 50% margin requirement, your positions are forcedly liquidated at -25% drawdown.
Sorry, it was early for me as well. I meant to write 1 instead of 4 (corrected in my post).
If the market goes down by X, I now have (1-X) N in ETFs and k X V in debt due to futures. The former should be at least double of the latter, hence my formula.
Let’s say the market borrowing rate is b and the future financing costs are b + m_f. These will be your final costs. For margin loan it’s more complicated, because you deduct taxes on the loan and get taxed on the dividends. So the costs for you will be (b + m_l)(1-r) + d r. Comparing the two, futures end up more expensive when b > d + \frac{m_l (1-r) - m_f}{r}. Putting some defaults like m_l=1.5\%, r=33\%, m_f=0.3\%, d=2\%, I arrive to b > 4.1\%. Hmm, that’s not that high, actually.
Also, in another thread it is claimed that only 65% of the dividends are priced in for the Swiss market futures (I haven’t fact-checked it). This makes the formula a bit different, namely:
b > d \frac{r-0.35}{r} + \frac{m_l (1-r) - m_f}{r}
For r around 35% the first term becomes rather small.
As of now, despite the lack of tax savings on dividends, the futures path is a clear winner for Swiss stocks, it seems.
Edit: except for the fact that the “micro” smi futures (FSMS) appear to be barely traded and the “regular” one (FSMI) is 10x the index, so more than 100k.
Personally I fudged the numbers enough times that IBKR’s algorithm thought it’s safe enough for me to put 500CHF in UPRO. Somewhere in IBKR they must have a picture of Coop Prix Guarantee Feta on an oil tanker or something
I thought I’d quickly update the thread. I studied the topic a lot over holidays (@Helix 's summary is one of the best) and decided that options would be the best for me. They are almost like futures, but you don’t have the risks of a margin call or extra taxes on dividends.
You pay a bit more, and finding an option that’s liquid could be a challenge (I find Swissquote’s UI to be quite good for that). So far I haven’t found any more downsides, but happy to hear from the forum.
I’m also only doing paper trading for now to figure out the mechanics of buying/selling and execution (seems to be automatic) and compare with unleveraged investments (there is a sizeable discrepancy so far, which I attribute to the downside protection: my virtual positions are all down so far). I also need to pay taxes in October, so don’t really want to put real money there yet
By reading and partipating to this forum, you confirm you have read and agree with the disclaimer presented on http://www.mustachianpost.com/
En lisant et participant à ce forum, tu confirmes avoir lu et être d'accord avec l'avis de dégagement de responsabilité présenté sur http://www.mustachianpost.com/fr/
Durch das Lesen und die Teilnahme an diesem Forum bestätigst du, dass du den auf http://www.mustachianpost.com/de/ dargestellten Haftungsausschluss gelesen hast und damit einverstanden bist.
). Can you provide a hint of their derivations?
