Speeding on leverage

Fifty Ways to Trade an Option

This one goes out to all my readers who treat the speed limit as the minimum.

The rules are a benchmark, and as you cut the Google Maps arrival time, alpha is generated.

Leverage is a lot like that. It’s not spicy enough until it’s too hot to handle. The risk of driving your portfolio harder is that at best you’ll be forced to slam on the brakes at some point. Traffic obstacles and tariff tantrums come out of nowhere.

Worst cases escalate. Blowing everything up is a game ender. But plenty of you also enjoy speeding - on the road or in the personal account.

There are a lot of bad ways to use leverage, and a portfolio can quickly get overheated. But maximizing capital efficiency on an existing edge is also just good trading.

Options strategies have the capacity to provide a LOT of leverage to a portfolio, so it’s extremely important to understand that edge first, and size appropriately. Just because you have the buying power, doesn’t mean you should use it.

Investors and traders can source many different edges. The simplest is to sit on your hands and let time pass. The hardest is competing against large and sophisticated institutions for mispricings in highly liquid securities.

If you can’t be boring and patient because it feels like there could be some improvement, you’re right. The next logical step however, is not to swing trade options based on guru chart voodoo.

The little bits of improvement follow an asymptotic curve. Every marginal degree of effort yields increasingly smaller rewards. The biggest gains come from the simple early steps. Regularly contribute to diversified low fee vehicles and you’ve solved the majority of the investment problem.

One relatively simple way to do “better” than just the index is to buffer it. Use a hedged equity strategy to perform the trick of a lot lower vol with only a little bit lower returns.

But if your eyes gravitate towards the multi-chili pepper section of the menu, there are better and worse ways to get that spice. Yesterday in The Till we talked about all of the little underlying complexities that can come from leverage. There’s potential to trip yourself up no matter what options overlay you’re looking at; turning the dial up makes errors come at you faster and larger.

With a 2x ETF or margin capital, the returns are just equities on steroids. The same risk premium, simply bigger size. But options have their own embedded risk premia that is less consistent and more variable than the equity version - volatility risk premium or VRP. If you’re swallowing that hot pepper, at least get paid for it.

Today in Fifty Ways to Trade an option, we’ll look at how to use options for leveraged exposure to both the equity and volatility risk premia.