I love the EFP from IB and i am all in on this product. But i've been thinking about a potential disaster scenerio. Could the spread actually go up as time pass? For example, MYL sept EFP spread right now is 0.0784. If MYL doubles in share price in the next week, the spread could actually double to around 0.16 give or take to reflect the same 5.50% yield. Not only the spread rise, and now you are down $1500 from the short futures position. As jimrockford previous suggested, we should unload some EFP as our balance start to get negative, but will we be actually be offseting the short EFP at a loss if the stock rise a lot even though time has pass? This is the only potential risk i see from the EFP. With that being said, i still like the EFP because the risk of a stock doubles in a short period of time isnt that big.
Yes, there is a risk that short EFPs can move against you temporarily, thus causing you to incur broker margin interest charges until the EFP expires or at least gets closer to expiration, or until you cover the short EFP. You deal with this risk by adjusting your EFP portfolio if its cash balance goes too far into the negative zone. If you do this, and if IB continues providing EFP liquidity, then the risk will be trivial, and can then be seen as a very small cost of managing the position, rather than a risk.
I was unlucky to sell RIMM EFP stock jumped 15% so it was quite a significant loss. I mean not rally huge but if I left my money as a cash I would earn more interest
This time, yes, but on the average, EFPs will sometimes move in your favor, and this balances out against the movements against you. You will, on the average, earn more selling EFPs than resting in cash at any broker. If your entire EFP portfolio is in RIMM, then you should buy back one or more of your RIMM EFPs, in order to eliminate your negative cash balance, because 15% is too big a move, for your entire EFP portfolio, to go without any adjustments. If this results in your having a lot of uninvested cash, then you should sell an EFP of a lower priced stock, in order to get your cash balance back to zero (neither too negative nor too positive). You can minimize this unpredictability of EFP returns by making sure that an appropriate portion of your cash is always invested in EFPs which expire in less than one month. This is the portion from which you will buy back EFPs, as needed, when an EFP stock rises and requires you adjust your EFPs by reducing the total value of their stock legs.
I am trying to say that the problem with re-adjusting the EFP of a stock that rose 15% in a short time is that the time decay might not be enough to cover the rapid rise in the EFP price. I think you shouldnt sell a EFP of a stock that you think it will rise. EFP is not riskless, but nevertheless, this is a good way to earn a couple of hundred bucks without a whole lot risk if you can pick a stock that goes down.
And i think it is not fair to compare it with cash that pays interest on long balance in a normal brokerage account. Cash that sits at a brokerage account doesnt have the risk of the balance going negative, commision etc. So i think is kind of misleading for IB to promote it as an alternative way to earn interest on extra cash. I think this is like another short term money market derivatives as opposed to risk free interest.
If the EFP moves against you, then you just wait until it expires, by which time any temporary loss will have completely vanished. You seem to think that there is a risk of having more than a temporary loss. The risk you are talking about does not actually exist. We are talking about very small fluctuations. If the stock suddenly jumps up 15%, then an EFP expiring in one month, at current interest rates, will only move against you by 0.07% of the invested capital: that is, by a mere 7 hundredths of a percentage point, or in other words, by a mere 7 thousandths of the total invested capital. If you simply wait until expiration one month later, then this 0.07% will be returned to you as a result of the time decay. So the risk you are discussing really does not exist, at least not the way you think it does. It is true that managing EFPs does require more understanding, and more activity, than just letting cash sit in your account. This extra burden is best seen not as a "risk" of using EFPs, but as a "cost" of using EFPs.
Is it fair to say that the real risk is that you are not guaranteed to earn the rate of return that the original position implied? I think so. If the stock moves down, the marginal amount credited to your account will not earn interest (< 10000). If the stock moves up you are stuck paying some margin interest. Not sure this is significant (1/4 percent?) in most cases.
Right! the 0.07% is exactly what i am refering to. Because if the stock goes up by 15%, you have 2 choices: a) Pay interest on the negative 15% at IB's rate (6.8%) b) Buy back the EFP at a 0.07% lost. Either way you lose. The point that i am trying to make is, the interest rate you see offer by the market makers is the best case scenerio. There are cost to the EFP interest if the stock goes up. But i think even with all the cost, it will be still better than nothing. The alternative to this is probably BIL, in the case of BIL, there is no risk of negative balance and no hassle of readjustment and you are buying the safest bonds on earth. The downside to it is you earn a below market interest rate. I think the tradeoff is would you take a gurantee 4+% or with the risk of a) b) and earn 5+%.
Stocks don't usually go up 15% in just one month. They are more likely to go down 15% in one month, instead of up 15%. The times when stocks go down 15%, causing you to earn extra profit on your EFP, balance out the times when stocks go up 15%, so that on the average, you will earn just a little bit under the displayed interest rate. It isn't reasonable to judge EFPs based on what happens in only one extremely unusual situation. They need to be judged based on their average performance over time. Would I accuse you of being a poor trader, just because you do occasionally have losing trades, or would I judge you based on your performance averaged over numerous trades?