Suppose you hold 150K of stock, but NOT in the form of EFPs. Suppose you bought it with 150K of cash, so that you didn't have to rely on the broker to extend you a margin loan. If the stock goes up, then so does your account equity. If the stock goes up, your equity goes up with it, so that the increase will not generate a negative cash balance, and you will not need to rely on a margin loan, and you will not need to pay interest simply because your stock increased. Now suppose, instead, that you are holding the stock as part of an EFP. EFP stock is hedged by the EFP's futures leg. If the stock goes down, you lose virtually nothing, because the short futures increase in value by almost the same amount. If the stock goes up, you gain nothing, because the short futures go down in value by almost the same amount. If your EFP stock goes up to $160K, but your account equity remains the same at $150K, then the broker must extend you a margin loan of $10K, so that you can continue to hold $160K worth of stock in an account having equity of only $150K. This is the source of your negative cash balance of -$10K. The solution, when this happens, is simply to readjust your EFPs so that your EFP stocks will maintain value close to your account equity. This is a different way of saying that you are trying to maintain a cash balance close to zero. If your EFP stocks go down, let's say, to a value of $140K, but your account equity remains unchanged at $150K, then you have a positive cash balance of $10K. This $10K should be put to work earning interest, but instead it lies there doing nothing. If this happens, then you should re-adjust by selling an EFP to put this extra $10K to work; otherwise, you miss out on the interest you should be getting. Note that increases and decreases in the value of your EFP stock leg will affect your cash balance in a way that the EFP futures leg will not. This is a very important asymmetry in how the two legs affect your cash balance. You want to avoid cash balances that get too far above zero, as well as those that get too far below zero. Another way of saying this is that you want to avoid holding EFP stocks that have value too far above, or too far below, the amount of cash you have reserved for EFP investing. I hope this explains what happened to your cash balance as a result of fluctuations in the value of your EFP stocks.
jimrockford -- Thx -- actually seeing the discussion again, slightly reworded, helped me greatly. You are right -- even a small increase can eats into cash (while a large increase is needed to exhaust margin). I missed that initially. But I think you have the legs reversed.... i.e. I think this should instead be: If the stock goes up by 10k, you are not being extended the margin loan for the 10k bec you paid for the stock already. However, because the SSF leg decreases by 10k, you lose 10k in mark-to-market on it.
Here is a question i have: Assume i have 10K in the account and want to sell 10K of EFP to earn interest. I sold 1 lot on a $100 stock. Now the stock rise to $150 and now i am paying interest on the 5K from the short SSF leg. So, the return will be less than when i first initiated the position at $100. From what i heard, one solution is that we should keep adjusting so that cash balance would not go too far below 0. Ok, say i unload the position a few days later at $105, but does the time decay in the EFP equals to the interest at 5+% for these few days? I mean, the EFP annualized interest rate depends greatly on the dividend and the time decay for these few days probably wont factor in the dividend.
I have to correct a mistake I made. I said that in order to minimize EFP adjustment costs, you should prefer higher-priced stocks, because they involve fewer shares, and therefore less commissions incurred in the process of adjustments. I was wrong. If you are doing adjustments correctly, then each adjustment will only involve buying and/or selling one or two or three EFPs at a time. Larger accounts will deviate further from a zero cash balance more than small accounts, and so larger accounts will adjust more frequently than smaller accounts, but no matter how big the account, adjustments will involve only one or two contracts at a time. Using higher-priced EFP stocks will have almost no impact on reducing adjustment costs. I had forgotten the fact that adjustments involve only one or two contracts, instead of the entire account, and this oversight led to my incorrect advice. It is still good advice to do the following, in order to minimize EFP adjustment costs: 1) Avoid volatile stocks. 2) Reduce overall EFP portfolio volatility, by diversifying among as many EFP stock symbols as possible. It is also still the case that higher-priced stocks will help to minimize EFP commissions when you establish an EFP portfolio; but this benefit will not be present in the context of adjusting EFPs, since adjustments are small compared to the overall portfolio.
Please don't PM me your questions, unless there is some compelling reason why you need privacy. Please instead post your questions publicly, and I will try to find time to answer them. I have spent so much time posting about EFPs that I really need to limit it. So I will try to find time to answer some of the accumulated questions when I can. Maybe other people can help as well, in the meantime.
I have to admit that I, and others were right about taking this EFP thing slowly, as there seems to be a laundry list of things to be aware of to do it right. Never do anything in the market that you don't understand , if not fully, then well.
I did a little of the EFP. Honestly, I've never been able to learn anything without actually doing. And here, any type of "painful" lesson is going to be the cheapest lesson you ever had. I mean think about it....what is there to lose? If the stock goes up, the future goes up...and vice versa. If it gets to the point that you want to close it out, no problem. Commission is dirt cheap. Spreads are good. If you do a short term EFP, let's say a month, what do you really think is going to happen in that month? LOL. OldTrader
I believe I understood how the EFP for spare cash yield strategy(starting flat) works. I however have not understood how the second strategy(using EFP for earning on short sales) works. Lets say I want to short MSFT and earn some interest on the money I will put up as margin that IB(as usual) doesnt pay. You need to short the stock then buy the EFP(short stock long futures) correct?, how will the interest flows occur here?Doesnt a long EFP position makes you pay the market interest rate, if so I dont get where is the benefit
OLD TRADER, I ran a martingale simulation on EFP sales that shows that 1 in 375 times, your account will be blown out, your home seized, and a black mark placed next to your nick , all within a 20 minute period on a very quiet day in the market. You asked.