Real risks of IB EFPs

Discussion in 'Retail Brokers' started by demoship, Jul 23, 2007.

  1. Ok, I'm going to make this very clear, short and concise, every risk I can think of off the top of my head related to EFPs:

    1) Mark to market risk. If the stock goes up, you're now up on the stock, and down on the future. The future gets marked to the market. This can cause you to have a negative cash balance. This also works the other way

    2) Spread risk. Let's say the stock is 100, interest rates are 5%. A SSF 1 year out will be 105, assuming zero dividends, and ignoring the bid-ask spread. This $5 is the spread between the stock and the future. IF the stock shoots to $1000 tomorrow.. The interest rate is still 5%, and the SSF is still approximately 1 year out (364 days, but for this example we're going to ignore that). The SSF will now be $1050.. a $50 spread. This means you lost $45 (and you WILL have to unwind the position, since the future will be marked to the market and you will have a huge debit balance). Of course, this is an extreme example, but gaining or losing 50% on the spread is certainly a possibility (look at AMZN!). This is very closely correlated with mark to market risk.

    3) Liquidity (and the bid-ask spread). The spread on the future is much wider then the spread on the stock. This means every time you adjust, you will lose a few cents per share (and since you're not getting THAT much in interest to begin with, this IS significant)

    4) Significant changes in dividends. If your 2% dividend paying stock suddenly stops paying the dividends. The SSF value will go up to reflect this, even if the stock value doesn't move. This is because the future takes into account dividends.

    5) Significant changes to the cost to borrow a stock. If a stock suddenly lands on the SHO list, I guarantee you the future value will go DOWN if the stock price does not move. This is because the stock is more expensive to borrow. The counterparty to your EFP must take the opposite position you do. If they have to pay more to short the stock, they won't offer as good of a yield on the EFP.

    Of course, EVERY RISK goes BOTH WAYS. You can see a loss or a windfall profit. EFPs are NOT risk free and are NOT simply a way to earn the best interest on your money. It is definitely a GOOD way, but BE AWARE of the risks involved!

    Oh, and one last thing, Don't bother trying to complain to IB that they didn't properly disclose the risks of an EFP. You have to request permission to trade Single Stock Futures, and in doing so you acknowledged that you know the characteristics and risks of futures contracts. Well, these elements I listed above are the risks of single stock futures, if you didn't know them, and lost money as a result, chalk it up to experience and learn from it :) Everybody makes mistakes!
     
  2. Nice list. Dont think theres anything there that wasn't touched on the the other threads.


    Wouldn't most of this risk be nullified by sticking to big cap names, and short durations.

    Selling something 6 months out may not be worth the extra risk a a move against you. The commisions are quite small, so reentering every month or two should not be a big factor.

    Item 3) From what I've seen the b/a spread that IB is making is usually less than a penny.

    Speaking of that, do you have to lose the 'weekend' to roll an expiration over to the next month or can you do this on expire Friday without a problem?

    I suspect it may depend on how much buying power you have in the account on that day.
     
  3. Actually, if you're selling the EFP (long stock short future), you should try to go for a name that you think will go DOWN in hopes of catching a windfall profit.

    And you should also go on a slightly longer time horizon then 1 month. Otherwise the fees will get significant.
     
  4. demoship,

    Everything you said is wrong.

    I have, in other threads, already written extensively about the use of EFPs to earn interest on cash and on short sale proceeds, greater than any broker will pay, and to finance leveraged long stock positions while paying less interest than the margin rate any broker will charge. I also intend to write about how EFPs can be used to increase buying power substantially above the normal 2:1 overnite and 4:1 intraday limits. The risks you allege simply do not exist.

    1) Let's first consider what you call "mark to market risk", the danger that if you invest free cash in a short EFP, the long stock leg may go up in value, thereby creating a negative cash balance for which the broker will charge you margin interest. If this occurs, you simply buy back the EFP, and replace it by selling another EFP with a lower-valued stock leg, so as to bring your cash balance back to zero. These adjustments will involve only insignificant commission and spread costs and margin interest costs, which will be dwarfed by the EFP interest earned. The cost of these adjustments is just a very minor factor, and cannot be considered a "risk" militating against the use of EFPs. The only risk here is that some traders, such as yourself, might not be smart enough to use EFPs properly, and therefore, due to lack of mental ability, are not able to enjoy the benefits of EFPs.

    2) Let's next consider what you call "spread risk". Your example of a stock multiplying in value by a factor of 10, and therefore causing a substantial (but temporary) loss is ludicrous. If your EFP stock is extremely volatile, you will simply get rid of that EFP and replace it with another EFP involving a less volatile stock. You will do this long before the stock increases in value enough to cause any significant loss. If you fail to do it, and simply hold the EFP until expiration, then your loss will prove to be temporary and will disappear by the time the EFP expires. Very small up and down fluctuations in the value of an EFP will still occur normally, but these fluctuations will be irrelevant because the value of the EFP will steadily trend to zero by its expiration date; and these flutters will be too small to be considered a substantial risk militating against the use of an EFP.

    3) Let's consider what you call "liquidity risk". Your facts are totally wrong. You say that EFP transaction costs include the very wide spreads which occur on SSFs. This is not true. IB and its customers, thru IB's "IBEFP" ECN for EFPs, make tight markets in EFPs, with extremely tight spreads which are typically a tiny fraction of the mile-wide spreads on SSFs. The spreads on these EFPs are often downright microscopic; for example, low-priced stocks which have a one-tick penny spread on the stock will routinely have a near-dated EFP with a spread the size of few hundredths of a penny. IB's EFP spreads are generally about 0.25% or so, on an annualized basis; so that for an EFP expiring in a month, your spread will consume about 0.25%/12 = ~0.02% of the principal amount. Not 2%. Not 2/10 of a percent. We are talking two one-hundredths of a percent for a one-month EFP! This is nothing! You truly have no idea what you are talking about.

    IB might, at some point, stop making markets in an EFP, so that you can't get out of an EFP immediately without sacrificing a few pennies or nickels per share. You can entirely sidestep this remote risk simply by riding the EFP until its expiration date. You can also minimize this risk by choosing soon-to-expire EFPs.

    4) Let's talk about what you call "significant changes in dividends". You can avoid even thinking about this simply by selling only EFPs which are not expected to pay dividends. I also find other faults with this aspect of your argument, but I don't have time to explore the various other ways in which you are wrong on this point. I will instead move on to the next point.

    5) Let's talk about the possibility that a stock will become hard to borrow, so that the EFP's interest rate will decrease. This is not a risk! A decrease in the EFP's interest rate will deliver you a substantial windfall profit! EFP interest rate decline would be a good thing, not a bad thing! Got it?

    This possibility of a substantial windfall profit is probably not very great, but thankfully, there is no corresponding risk in the opposite direction, from a stock that was hard to borrow suddenly becoming normal. This is because the wise trader or investor, in selecting the stock for which to sell an EFP, will choose an EFP yielding the highest available rate of interest compared to other EFP stocks; and this will automatically eliminate any such risk.

    It is possible that short-term market interest rates might increase. This would produce only a temporary loss, which would gradually disappear as the EFP approached expiration. The only disadvantage would be that you would earn the market interest rate which had been in effect at the time you entered your EFP, and you would miss out on the more lucrative, higher market interest rate which became established after you were already in your EFP position. This is exactly the same kind of risk posed by US treasury bills.

    EFPs are essentially risk-free, for the trader who actually understands them. Your argument shows that you are confusing the risks of an unhedged SSF with the infinitely safer, hedged EFP. The two greatest risks they pose are:

    1) The trader isn't smart enough to use them properly.

    2) The OCC, which acts as clearinghouse, as a guaranteeing buyer to every seller, and a guaranteeing seller to every buyer, of an SSF or of a US equity option, might collapse, thereby defaulting on your EFP's short SSF leg at the same time as your EFP's long stock leg also collapsed in value, BUT the collapse of OCC could only occur as part of a system-wide, total financial meltdown, which would probably destroy life as we know it in the United States. If something like this happens, you are most likely going to have problems a lot bigger than trying to protect your finances. You probably won't need stocks, bonds, or even dollars. You'll need water, food, and shotgun shells, and probably nobody will be interested in your dollars and other worthless paper assets. We would probably be going back to the Stone Age, or even worse. If you can't take the risk of OCC collapsing, then you shouldn't trade SSFs or invest in anything at all, and you should just buy gold and hide it. I think the U.S. government would have no choice but to bailout OCC if it failed, so that the country might continue to have at least some semblance of financial markets.

    It really is a shame that so many people on ET will dispense misleading and harmful advice on topics about which they know nothing.
     
  5. Wrong. The fees won't be significant.
     
  6. 1) It sure as hell is a risk. If the stock/future goes up and you have to adjust your position, you have to lose a couple cents on the EFP, and lose a cent on the commissions (2 ways). If you have to do this often enough, it IS an issue.

    2) Stocks moving up / down 20% happens. Look at MMM, they're one of the most stable companies around, they went from the 70s to the 90s.

    3) Plenty of the EFPs have > 1 cent spreads. spreads of a nickel or slightly more are common.

    4) How do you know if a company is going to declare dividends or not? Microsoft did it and nobody expected that a few years ago.

    5) (this goes for all points). I'm listing risks for BOTH sides of an EFP. The person who's short the stock and long the future will get hit if the stock becomes hard to borrow.

    Again, it's a GOOD way to get interest on your free cash balances, but there ARE risks involved.

    jim, I don't know what kind of idiot says that spreads don't mean shit, when every time you go into/unwind an EFP, you're losing a few % of the potential profit to be made. Keep in mind that for a 6 month EFP on a $50 stock, you're only making about $1.25 on it, NOT including transaction fees and spreads. If you have to adjust the position and spend $0.10 / share (which YOU call insignificant), that's 8% gone. And if the markets are volatile, you can easily spend more then that.

    Go try telling a daytrader that the 1 cent spread on liquid stocks doesn't mean anything. Slippage is an issue with EVERY security.
     
  7. 1 month, $50 stock, 5.25% interest rate.

    You get 21.875c on a 1 month EFP

    There's probably 1 cent in slippage, and .5 cents in commission.

    That's a 6.857% commission/slippage.

    If you go further out, 1/2 a year


    $1.3125 on a 6 month EFP
    Since it's further out, there's probably 3 cents in slippage, and .5 cents in commission.

    That's a 2.667% commission/slippage. Less then half.

    That's significant.
     
  8. A 0.25% spread is more than "nothing", it's the difference between a high-yield EFP and IB's MM rate on balances over 100k. Hopefully, you pick the right stock and won't need to adjust often, otherwise you will lose money on the b/a spread for each adjustment. Do it enough times and it'll eventually negate the yield advantage.

    Not to mention, your schedule D is gonna be longer than if you just parked the cash in IB's MM.

    To me the big advantage isn't the yield advantage -- due to the fact you have to babysit them and they will add work during tax time. The advantage to them is increasing insurance for cash from the $1M limit at IB to $35M because you're converting cash into stocks (btw, SSFs are not insured). But there's probably like 5 people on this board who care about this reason.
     
  9. Not a bad point. Just remember though that the Lloyds insurance is subject to an aggregate limit of $150 million. What this means is that if IB has alot of accounts that exceed SIPC insurance, you may not have full coverage under the Lloyds policy.

    That said, it clearly converts cash to securities even under SIPC.

    You could buy T-Bills for accounts with over $1million and effectively convert your cash to securities. No state tax, and less effort, somewhat smaller return pre-tax.

    OldTrader
     
  10. Are you sure that's what aggregate limit means? $150M is miniscule for IB, which has billions in customer equity. Even the policy at TOS has a $200M limit and TOS is about 1/10 the size. I always assumed it meant that was the total of all your accounts that Llyods will insure (you can have accounts at other brokers that are insured through Lloyds).

    If $150M is for all of IB, that would be like someone insuring their $350k house for $25k.
     
    #10     Jul 24, 2007