Debit Spreads

A friend send me the URL to  website that gives trade recommendations using debit spreads for the QQQQ EFT. He mentioned that the profits were small in dollars, quite consistent,  and have high percentage return. 
The returns range from 40% to minus 45%. The (arithmetic average is 25%). He seemed  impressed, and asked for my opinion.  Their spreads are 2 dollars wide on the QQQQ which trade in the upper 40s. Below Should he be impressed or not? Here is my analysis answer.


1. Their spreads are about $2 wide, which if you project to the QQQQ value, is bout 4%. The leverage is therefore 25. Why is this important? Because if you adjust to leverage, the return is only 0.65% per trade. If you project it for the whole year, and assuming always a trade is on, you get about 3 to 4% annualized. The leverage adjusted return is even lower. Why: check points 2-4.

2. What is shown is arithmetic average of the return, not the geometric average , which is the true return. Geometric return is always less than arithmetic, and if you add the no trade time periods, your return is much less that 3%.

3. Other problems: you have to divide by another factor (which is higher than 1), because the beta of the QQQQ is higher than the beta of the market.

4. No dividend is in there, while you receive it in the QQQQs.

Conclusion, the return  adjusted for  leverage, risk, dividend is probably around 1.5%.



One related conclusion: people use leverage to get high return, when in fact the reverse is probably better. Why? Because if one can get a positive no risk return higher than the borrowing rate, and then one can leverage it. 

One should pay attention to  returns that involve leverage because  leverage can lead to good looking returns which can deceive the eye, when in fact the returns can be less than risk free returns.