A detailed discussion of using futures contracts to obtain leverage; holding a long position of the S+P 500 index

by devdevdev51

In another post, I reviewed some of the ways to obtain leverage in your portfolio. Here, I discuss futures specifically.

Futures may be the most cost-effective way of obtaining leverage, or are at least comparable to options. With index futures, you enter into a contract to buy or sell the index at a future date (NOT optional), and the notional value contract can be 5x, 50x, or 250x the underlying index (in the commonly traded CME group contracts). Depending on how much capital you commit to the margin (a sort of good faith deposit), leverage can be anywhere from almost 0x up to 25x if your margin requirement was 4%. This position can be rolled forward quarterly, and leverage will increase if the index loses value and decrease if the index gains value.

You do not earn dividends, although this is reflected in the futures price (Future Price = Spot Price * e^((Financing Cost – Continuous Dividend Rate)*Time to Maturity). When interest rates are high, the exponent is positive and the futures contract trades at a premium; you can end up paying a significant amount of roll adjustment in a market in contango. When interest rates are lower than the dividend rate, the exponent is negative and you get a discount for buying a futures contract; a market in backwardation is helpful for those looking to hold a contract long-term. Note that this roll adjustment does not occur when rolling a contract forward, but rather gradually over the life of the contract.

While all that might sound complex, the effect of contango/backwardation has not been substantial over the past 20 years as a whole because interest rates have been both higher and lower than the dividend rate. Let’s say we decide to trade the E-mini S+P 500 contract, where the contract size is 50x the index. If you were to enter into a futures contract in 2000 when the index value was ~$1400 and roll it quarterly, you would be forced into a margin call and essentially wiped out in 2008 with any amount of leverage >1.5x (starting balance of ≤~$47000). If you “rescued” your account and injected enough cash to avoid margin calls, you would have had to put up ~$4500 at the worst of the recession, and turned your $47,000 into ~148,000 in December 2019. This sounds great, but if you had simply invested your initial capital plus the $4500 in an S+P 500 index fund and reinvested dividends, you would have ~$164,000 with much less risk. “Rescuing” your account when starting with higher leverage has similar results, with higher ending balances, higher “rescue” requirements, and similar returns to the S+P 500 with dividends reinvested. By the way, releveraging or hedging your account by going long or short on Micro contracts (contract value 1/10 the Emini), you would do even worse.

Of course, if you started with $47,000 in 2010 and rolled forward 2 E-mini futures contracts (2 because this results in starting leverage of 2.36x compared with 1.2x for 1 contract) until 2020, you would have ended with ~$269,000 compared with the S+P’s return of ~$165,000. So, if you could somehow time the market, leverage obviously does well.

The only way I found of consistently beating the passive index holder since 2000 was to “double down”, or invest more money AND increase your leverage by buying additional contracts every time the index drops significantly. Let’s say you decided to start at 3x leverage with ~$24,000 committed, then trade an additional contract (increasing your leverage, requiring extra money to be injected into your account to avoid margin calls) every time the index dropped to 2/3 of its starting value ($952 for our example of starting in 2000 with the index at $1429), and wait at least a year to “double down” again. You would have started trading 2 E-mini contracts after the dot-com bubble burst in 2002, 3 during the 2008 Great Recession, and maintained those 3 contracts until December 2019. You would have injected ~$36,000 (more than the value of the initial account!) and ended with a final value of ~$427,000, compared to just investing your original $24,000 + $36,000 in the S+P 500 (reinvesting dividends) and ending with ~$191,000. Of course, this requires serious resolve and access to extra cash when the economy is at its worst. My next plan is to test this strategy over many time periods.

The final consideration is taxes. If you invest in a taxable account, you will be on the hook for only the long-term capital gains tax of 15% with stocks and ETFs, and you can realize those gains at the end of your investing period. LEAPs and futures are subject to the 60/40 rule, where 60% of your gains are taxed at the long-term rate of 15% and the other 40% is taxed as short-term gains (taxed as income), and you have to do this every year (although you can tax-loss harvest).

TL;DR Leverage results in greater gains and greater loss, but can be expensive to obtain. Options and futures are the most cost-effective way of obtaining leverage. Holding a leveraged long position with options and futures is possible, but can be completely wiped out with severe drawdowns. An aggressive futures trading strategy of increasing your leverage and cash committed every time the index loses significant value could be profitable if the value of the index increases over time.

Does anyone here use futures to obtain leverage?

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.