2023-12-15 14:01:27 ET
Summary
- TQQQ, a leveraged ETF, has gained 185% this year but is still below its level from January 2021.
- The article suggests a strategy to take profits off the table while still retaining upside potential.
- By selling shares and purchasing call options, investors can lock in gains and limit downside risk.
What else can we say about the gains this year in Invesco QQQ Trust (QQQ) and ProShares UltraPro QQQ (TQQQ) that hasn't been said already? I have something. And for those sitting nervously on abnormally high unrealized gains on QQQ or the leveraged version of it, there's a strategy I've used often that might be useful to know about.
TQQQ is an $18 billion ETF that debuted back in 2010. Its popularity is a clear reflection of the desire among many investors to take an already volatile part of the stock market, and add another gear, so to speak. Typical of a levered ETF, it trades an average daily volume of about $5 billion, or more than 1/4 of its total assets. That implies that the ETF's assets turn over completely within a week, on average. That's wild, but the reality of modern markets, and one of many types of trading flexibility that ETFs have brought to investors.
I use TQQQ and other 2x and 3x leveraged ETFs, but very, very sparingly, in miniscule size. I need to have supreme confidence in a move to do so. I'd rather play it straight without leverage... or purchase call options to get that leverage, but while defining in advance the most I can lose.
TQQQ is up 185% this year, a remarkable figure, even accounting for the 3x leverage. But to show how much of a roller coaster that approach can be, TQQQ is still selling below its level from January of 2021, nearly three years ago. So it's not a double-edged sword, it's a triple-edged sword! So I'll offer an alternative way to approach these strange times for Nasdaq 100 investors.
The bottom line is that all of these things can be true at once:
1. Take some profits off the table in the ETF (don't forget to congratulate yourself!).
2. "Dare" the market to keep going higher, but do so in a way that puts far less capital at risk, but offers similar upside potential (or more) if this part of the stock market continues to go parabolic.
3. Continue to manage the overall position in this highly-appreciated security according to your own preferences, while better defining your risk but not capping additional upside.
4. Relax a little, knowing that you've just used market liquidity and risk-management techniques to capitalize on your original good decision to own QQQ or TQQQ.
I've done this many times over the years with a variety of ETFs, and even some stocks. QQQ is the subject here, but any ETF that you have a big gain in and that has a reasonably liquid options market is fair game for this strategy. While many parts of the stock market are just waking up from a nearly 3-year slumber (small caps, non-US stocks, energy and REIT sectors), QQQ and others are riding high. That makes this an ideal time to get creative, with the goal of keeping upside potential intact but slashing risk.
Note that I am not accounting for any tax-related factors here. That's' really outside the scope of my role as an ETF analyst and market strategist. Naturally, if this is all done in a retirement account, the realized capital gains issue is likely avoided. But I'll focus on the concept and process, rather than potential tax implications, as this is not personalized advice, it's research and opinion.
Goal: cash out a big winner, retain lots of upside, cap the downside
Here is an example of how this might look. This does not reflect an actual trade I've done in this case, but it is structurally the same as what I've done for many years.
Let's use the following assumptions:
* Bought 100 shares of QQQ in early January 2023 at $270 a share ($27,000 purchase cost)
* Reviewing that position at market close on 12/14/23 with QQQ at $403 a share (so the 100 shares are now worth $40,300, an unrealized profit of $13,300)
* Call options on QQQ with February 16, 2024 expiration date and $410 strike price cost $8.50. In other words, the cost of the options is about 2% of the strike price.
Now, let's put this strategy into action:
* Sell the 100 shares, cash in the profit of $13,300
* Buy 2 contracts of the call options outlined above. That costs $8.50 x 100 shares/contract x 2 contracts = $1,700
Summing up what I just described
1. The gains on QQQ are locked in, and even if the options went to zero, the profit on the QQQ "experience" is still over $11,000.
2. The most that can be lost from here forward is the $1,700 paid for the options, which would only happen if QQQ fell quickly and sharply, and I did nothing about it. Otherwise, some portion of the option value will remain until that expiration in 2 months.
3. Root like heck for QQQ to keep flying higher. Party like it's 1999 for the QQQ! (for those that get the historical and musical references).
There are 2 ways to view the options position that replaced the QQQ ETF holding. If QQQ heads up toward that $420 strike price (only about 4% higher from here, with 2 months to get there), the value of the call options should increase. Now, with options being assets whose value wastes away a little bit each day due to their limited life span, the faster QQQ moves up, the better.
That's why I tend to only look to this strategy when I can also feel confident that the upside potential is there. I've charted stocks and now ETFs since 1980, so when I see a good chance of a continued rally or even a runaway upside move as I do with QQQ currently, this strategy is a lot easier to put on with confidence. In addition, volatility is so low these days, the cost of buying options is as cheap as it has been in years. That's what a confident, exuberant market provides to us. Clearly, there is always a risk, but we are not paying much for those options versus if the market were nervous and QQQ were spiraling downward.
The other way to view the options is in terms of their "intrinsic value" at expiration on February 16 of next year. Let's say that QQQ did what it did in early 2023 when it vaulted 15% higher in the first month of the year. If that happened from here until the February 16 expiration day, it would put QQQ around $460.
That makes the options worth $40 each, or $4,000 per contract ($460 value of QQQ versus $420 strike price, which means I have the right to buy QQQ at that price until the expiration date). In this example, I bought 2 contracts, which control 200 shares, twice the number of shares owned outright at the start of this example, so the options would be worth $8,000. I paid $1,700 for them, so that's a tidy profit of $6,300, or 370%. Not bad for "riding the QQQ wave" but with only $1,700 at risk.
Finally, if I had held the 100 shares instead of swapping that position out for the options, they'd be worth $46,000 or $5,700 more than the day I sold QQQ in this hypothetical example. So think about that: if the goal was to "crush it" more with QQQ, I would have risked $1,700 to make $6,300 instead of risking $40,300 to make $5,700.
Investment management = Risk management
I'm a risk manager first. I say it and write it all the time, and typically apply that mantra to ETFs and the strategy around them. But in this case, I wanted to communicate how risk management can also be synced with an aggressive strategy using options. But how "aggressive" is it to do what I described above? I'd argue that it is much more prudent than aggressive. I'm sure there are many casino strategy analogies here, but I'm not much of a casino guy (I love horse racing, though!).
This example just scratches the surface, but the key takeaway for me is that we get these moments in market history where the market threatens to go parabolic. But that also courts elevated risk, given the move we've already seen in QQQ. Some would argue that TQQQ could be used to replace QQQ instead of using options, whereby I could put a fraction of the QQQ value sold into TQQQ and get that levered effect. If the VIX were at 20, I'd look more closely at that alternative. But down around 12-13, this is the closest thing to using leverage like a hedge fund manager I can think of. All the while, I know exactly what my worst-case scenario is.
I stay awake at night thinking about investment strategies to sleep better at night (if you get the pun there). This is one that works for me, and I hope it helps investors expand their field of vision a bit. At unique times like these in the market cycle, we need every edge we can get.
For further details see:
Big Winners In QQQ, TQQQ Can Use Options To Relax More, Skip The FOMO. Here's How.