Are We at an Inflection Point?

The market took a big dive this week. In fact, this whole January the market has been crashing down. This is the third year in a row that my portfolio has taken a hit in January. Maybe I’ll learn my lesson in 2023 and take a break to start the year.

The million-dollar question is does market finally believe that the Fed is going to raise rates and tighten liquidity? Or is this a typical market drawdown thanks to a sizeable OPEX that expires today? If the latter is true, we may see a strong rally next week as a lot of delta hedges are being taken off. This could happen by Tuesday or Wednesday. But if it is the former, Powell could try to save the market at the FOMC meeting.

It is probably wise to take chips off the table when there is so much uncertainty. I’m thinking that if there is no snap back rally next week, then we are really heading towards bear territory.

This week, I closed all my short puts in my short vol fund. I was thinking there were dangers ahead on Wednesday and I decided best to unload most of my stuff on Thursday morning. The timing was lucky as the market headed up initially in the morning. Even though it started to look like I’ve timed it wrong again, the market eventually headed back down and confirmed my initial belief. Today I unloaded remaining puts and short a lot of calls instead. Today’s fake rebound, however, cost me a lot because I thought I got the direction wrong. I must remind myself to wait sometimes. Nevertheless, I’m glad that I de-risked almost everything as I await to see what next week might bring.

Unfortunately for my personal portfolio, it is loaded with a lot of SPY LEAPS. Most of these LEAPS are in the money. I am suffering quite a lot in the portfolio because of it. As anything that is levered, it is always wonderful on the way up, but painful on the way down. I’m doing my best to hold onto these positions as a lot of them are maturing in 2023 and I feel like holding them to see where they are headed. The only thing I can do now is to sell SPX calls everyday hoping that the market doesn’t fall further than the premiums I can receive. Doing this in a sense will limit my gains if the market bounces back. But alas, one must survive to keep playing.

SPX YTD is down 8.31%. So at least one portfolio is outperforming the index.

Transaction and Taxation Costs are The Enemies of Great Returns

I want to illustrate a recent example of how I looked at a particular real estate holding of mine to show the ruthlessness of transaction costs and taxations to one’s investment returns. I will later try to tie this concept over to how I manage my equity portfolio.

I have a rental property that I purchased back in 2013 for $162,500. The current market value is $384,000. I have a loan against the property at $148,000. So my equity in the house is at $236,000. The question is, can I get $236,000 by selling the house? The answer is no.

First, let’s dive into transaction costs. I would have to pay about 5% transaction costs (2.5% realtor commission + 2.5% in transfer taxes, title companies etc). I get to save 2.5% more because I’m a real estate agent myself. As a result, transaction costs would come out to about $19,200.

Next, let’s look at taxes. You can expense depreciation against a rental property annually. But once you sell, however, you would have to pay for a depreciation recapture, which is 25% of the total depreciation you ever took. The amount is counted as ordinary income. I have depreciated the house for about $42,000 over the years. 25% of $42,000 comes out to be $10,500, which would be counted as ordinary income.

In additional, because I’ve depreciated about $42,000 over the years, the property basis is now at $120,500 ($162,500 original basis – $42,000 depreciation). As a result, the long term capital gain is at $244,300 ($384,000 sales price – $19,200 transaction costs – 120,500 current basis).

Let’s say at the moment the taxation at the short term ordinary gain is at 37% and long term capital gain is at 23.8%, we would multiply the STCG ($10,500 x 37%) and LTCG ($244,300 x 23.8%) and arrive at  about $62,028.

At the end, I would net about $154,772 [$384,000 (sales price) – $19,200 (transaction cost) – $148,000 (existing loan) – $62,028 (taxes) = $154,772]. The original equity of $236,000 has been cut by 34%. In fact the transaction costs of selling this house in total would have been about 21%.

In conclusion, to extract an additional $236,000 in equity would have cost me $81,228. It would have been an extraordinary waste of capital.

On the other hand, if I were to refinance the property, I can take out in loan 60% of the property value. By doing that, I would be able to take out a loan of approximately $230,400. The loan will replace the existing loan at $148,000, leaving me an extra $82,400 in capital. While this amount is not a lot, I would not have to pay any significant transaction costs other than maybe a couple thousand in mortgage fees. At the same time, I maintain an exposure to real estate, I can continue to collect rental income and lower my tax exposure by depreciating against the property and paying interest. The value in simply not selling is actually quite significant.

In the longwinded illustration of such example, I would say the same can apply to how I invest in my portfolio. Ideally, I want to be like Buffett – own every stock or index for as long as possible. While I admit we all have liquidity needs in some place or time, the most important thing is not to sell anything in the portfolio to get additional liquidity. Every time you have to sell a stock to pay for something, you’d most likely end up paying some form of capital gain tax on the position. There is no reason to incur taxes if you don’t have to.

I use margin loans for any liquidity needs. Instead of liquidating a position, I just take on additional debt. While most see this as risky because there is a possibility of getting margin called, I’d say it would be even more risky to sell a stock at the wrong time (and incurring transaction costs and taxes along with it). Interactive Brokers offers extremely low margin rates. I don’t know how other brokerages have been charging usury rates on consumers. But I’d say if you can get portfolio margin and uses Interactive Brokers to draw out capital when you truly need it, it is a much better way to increase your returns in the long run.

Now for one more tie in. I use LEAPS to purchase an equity position – this is almost like putting a down payment for a house. Just like a house, I am really putting down just 20% to own a position for a couple of years while paying interest. Like a house, if the stock drops, I can only really lose what I have put down. But if the stock goes up, my returns multiply because my initial investment is highly levered. Furthermore, if the value goes up by the exercise date, I can exercise the option and buy the stock instead of selling the option for a profit. Because remember, if you sell it, you’d have to pay taxes on your gains. By just buying it, I may have to take a margin loan to hold this position – but now I’d avoid taxes and transaction costs while at the same time the margin interest is tax deductible. The only risk difference is that while a bank can’t call your loan if the house falls in value, a brokerage can make a margin call. Nevertheless, like what I do, it is all about managing risk while increasing returns.

The moral of the story is to do your best to avoid transaction and taxation costs. These twin evils can shave away your returns and it can compound to a terrible monster over long periods of time. Keep that in mind every time you buy or sell something.

Rough Day in the Market 1/5/22

Definitely a rough day in the market today. The Fed minutes sparked real fear in the market and everything started tanking once the minutes emerged. I forgot about the minutes today to be honest. I would’ve likely held off selling some options had I known.

In my portfolios any time there is a significant down day they end up looking extremely ugly. In my short vol I was down 5.4% and in my personal I was down 7.77% for the day. So I ended down 3.56% and 3.84% YTD on the two portfolios respectively. Given YTD for SPY is -1.95%, I think it is okay. Of course, if the market drives further down the next few days there would be a bit of stress.

The reason today looked bad was that I had a few short deep in the money calls on SPX that gave me extra courage to take on riskier positions. Even though these deep in the money calls are great to hedge against drops in the market, any drops beyond what the strikes are we can quickly head into dangerous territory. I don’t usually close out positions quickly because I tend to wait for the volatility to play out. That has been a pretty good strategy throughout 2021 – and in 2021 there had been quite a few ugly days like these.

The rest of the week I will focus on protecting the existing positions by not selling more puts and rolling some SPX puts if necessary. Although I’d argue these are great times to sell volatility given the huge spike, I always end up in a bind where I’d prefer to protect my positions than to push to the limit. It only takes one weeklong blow up to wreck the whole year. Profits will always be waiting as long as you don’t get blown out of the game.

I don’t know if it’s a better strategy to just sit around and wait until volatility to spike to sell volatility either. Sometimes these spikes come few and far in between. You might end up sitting for quite a long time. The itch to trade and the opportunity cost of foregoing premiums while the market move sideways or up are high. I’ve been doing more of that in my retirement accounts. But boy, it is hard sometimes.

I’ll have another short recap at the end of the week. May Powell be with us.  

Year End Review

Year end return on my short vol strategy
Year end return from my personal account

2021 has been a banner year for me. It is the first year that I truly committed a large portion of my capital to the stock market. I created my first trading entity where I focused on a strict strategic direction – shorting volatility. The return was 78.87%. For my personal account I have done far better. The return was 187.43% for the year. SPY returned 25.90% for the year. So it is safe to say I’ve beat the index in 2021.

By separating my short vol strategy away from my personal account, I can see more clearly how different strategies generated different return. In my personal account, I had a lot more individual stock holdings, but most importantly, I owned a large amount of LEAPS on SPY as well as a bunch of individual stocks. A majority of those were purchased last year and most of them are set to expire in 2023.

Given I owned a lot of convexity in my personal positions, I experienced way more volatility – but at the same time, way more gains compared to the gains in my short vol account. Throughout the year, we had periods of intense volatility in which weekly changes to the S&P were going up and down 5%. The personal account endured a lot of stress but holding on proved to reap amazing returns. Max drawdown for the account was 23.33% while the S&P was 5.21%. Standard deviation was 3.53% compared to S&P’s 0.81%.

The short volatility fund, ironically, never got hit too hard despite the large swings. In fact, each big downturn created a period of strong belief that selling volatility would be safe. The irony is that when market is strong and VIX is low, selling volatility would expose you to big losses if you don’t control your risk appropriately. Max drawdown was 11.97% and standard deviation was 2.23%.

I can’t say for certain we’d have just as a strong a year in 2022. Since most people are thinking that the Fed will taper and raise rates in 2022, I think there could lie a surprise for us where 2022 can be just as strong. I will be tracking closely the bond rates and see if there are any yield curve inversion that could signal something different.

The short vol strategy would most likely continue to build up additional capital for me. At certain periods that would allow me to add more long term options to my personal account as we are getting access to options expiring in 2024. While these two strategies working in tandem would create the ideal portfolio, I’d put most of my focus on the short vol strategy as this is the strategy I’m looking to eventually launch in the future. After all, nobody gives you credit for your performance in a bull market. It is how you perform during periods of stress that proves you are truly capable.

In 2022 and beyond, I will document on this blog on a weekly basis my returns on both of my accounts. I would not be adding additional capital to my trading entity. I think that would create a clearer understanding of how I am doing. It wouldn’t be fair for me to add capital into it when it is stressed as I would kind of see that as cheating. I want the short vol strategy to perform as I intend to without outside assistance. On the other hand, I would add or subtract from my personal account as I see fit (I got a family to feed, houses to buy/sell, a bunch of liquidity needs beyond the scope of this blog). I will still be tracking it using money weighted returns but nevertheless it would probably not end up as an accurate reflection of my performance.

Using Options as a Hedge for Concentrated Holdings

One of the major worries of someone working for a public company is that most of their net worth will be tied by the fortunes of that company alone. This is especially prevalent in tech companies. Many ask whether it’s in their best interest to diversify into something else. While it is usually easy to say yes, diversifying can be a double edged sword. The company can grow quickly and its valuations can continue to skyrocket. In these cases, the opportunity cost of you not tying your investments with a company you know is tremendous – something you’d probably ignore because you probably don’t want to go back and do the calculations and see what you’ve missed.

I think a good idea to this problem is to use long term options as a middle ground between these two sides. While most people think to protect their stock position they have to use puts, I’d argue using a long term call option (LEAPS) in this instance has the ability to waste a lot of money on premiums.

I believe using LEAPS can protect your concentrated position because you gain an option to purchase the stock at a price in the future without you tying up all of your capital. You can sell all of your stocks in the company and at the same time purchase enough LEAPS to match the value of your position. For example, if you have 10,000 shares of Apple, at a market price of say $179.04 (as the date of my writing), you can purchase a 100 call options of Apple dated 1/19/24 at $180 for about $32. The original value of position was $17,904. You’ve spent $3,200 to buy this call option instead, which is only 17.87% of your capital. You are left with $14,704 in cash to invest into something else.

Of course, the problem with buying the long dated call option is that in order for you to break even, the stock has to rise above $212. So the stock has to rise at approximately 8.2% a year in order to reach that point. While it does seem to be expensive, but the key is that any subsequent rise in that stock would be compensated by the fact that any rise after 212 would be multiplied. In fact, you’d get about 6.6x return for every 1% rise above 212. Don’t forget the main goal here. We don’t want to miss out a strong rise in the company’s stock price if you are being paid in stock by the company. It is almost like buying insurance for the future where you won’t miss out on your company’s further success.

With the remaining $14,704, you’ll be free to use it to diversify your investments into something else – whether that can be bonds or index funds. If you’re more bullish, I’d suggest buying index funds as that’d serve your intention to diversify your investments. If you’re more bearish, you could purchase some US treasuries, possibly short term ones, so that you can react quickly to opportunities should they appear before 1/19/24. I would go with index funds.

Hopefully that gives you an idea how using options can create a middle ground in these types of situations.

The purpose of this blog

I want to document my journey in my attempt to outperform the index over the next three years. Throughout the journey, I will talk my thoughts and my trades as well as concepts I’ve come across and lessons I’ve learned.

The overarching strategy of my investment thesis is to use equity derivatives to achieve my returns while managing volatility risks. As Buffett use to say, I’d rather take a bumpy 15% than a smooth 12%. In the bumpy up and downs of derivatives lies a lot of values that normal investors would stay away from. Having started this path since 2019, I’ve slowly built up a lot of experience in equity derivatives without the usual academic or mathematical backgrounds.

While outperforming one year can easily be attributed to luck, I’m hoping to build a track record that I can consistently outperform the index. By documenting the process, I hope to articulate my strategy in real time. At the end of the run, if I do well, I want to create a fund and bring in investors. Being able to create values for more than just myself would be my ultimate achievement.

After all, one can argue that the simplest way to beat the index is to lever the portfolio to a certain percentage and hope that the next downturn won’t trigger a margin call. In December 2018 and February 2020, I came close to getting margin called because I was too overlevered. I thought interest rates were low and I was taking more risks that I thought. Thankfully, those periods I did truly commit myself into equities as the majority of my capital was tied to real estate. But it taught me a lesson that lumpy returns do require a significant amount of monitoring and care. It is truly through a bear market that you can see whether you are truly a good investor or just got lucky in a period because of leverage.

In 2021, it was different as I truly committed a significant portion of my capital into this venture. For the first time, any bad decisions would have had a serious effect on my net worth. So having done well in 2021, I’m looking forward to 2022 and let’s see if I can outperform the market again.

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