On the reading list…

I’m now reading a book called Enhanced Indexing Strategies: Utilizing Futures and Options to Achieve Higher Performance.  The general idea is to use relatively ‘normal’ return distributions (e.g. stock indices, as opposed to single stocks), combined with leverage (futures and options), to enhance portfolio returns.

I mentioned in an earlier post some life cycle portfolio research suggesting young people ( < 40 years old) use leverage to enhance stock returns.  This book, then, gives research on index selection and methods of leverage.  In general, I agree with the book’s main tenets for using leverage (from Chapter 1):

  1. Only use leverage if expected returns exceed costs of leverage.  Costs of leverage include interest, if using margin or other loans, or futures roll/lost dividends/extrinsic value for derivatives.
  2. Have enough cash or cash flow readily available to cover margin calls/interest. Simple idea here: the real risk of a leveraged portfolio is forced selling at a bottom, due to a margin call.  So keep enough cash around to cover that eventuality.  In my mind, this argues for using options rather than futures, and definitely rather than conventional margin.
  3. Loan terms will not require forced sale if underlying declines a significant amount.  Repetition, but worth it.  Again, in the retail world this would argue for option positions over futures or margin.

In our portfolio, I’ve mainly utilised bullish diagonal option spreads to replace long index positions.  This has the triple benefit of:

  1. Defining maximum loss (i.e. the net premium paid).
  2. Leveraging returns (e.g. notional value of the options position can be multiples of the underlying).
  3. Opportunity to profit from time decay and volatility increasing.

Hopefully the book will offer other methods to use options for index investing.

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