On the path to early retirement (and most likely in early retirement as well), the ERN family will be writing options to generate passive income (in addition to equity and real estate investments, of course). This may be something that people either haven’t heard before or even if they did, they might be turned off by the involvement of derivatives. After we got over our initial aversion against trading exotic instruments like options we found that it’s actually a reliable and profitable strategy to generate passive income. We mentioned this strategy already in a previous post on trading derivatives on the path to FIRE and thought that others might find this interesting too.
Today, in Part 1, we will do a quick intro to cover mostly the conceptual aspects of this strategy. Part 2 will go into how we actually implement our strategy. As a warm up, though, let’s start with a …
Pop Quiz:
Since 2000, the SPY ETF (S&P500 index fund from iShares) returned about 101% (Dec 1999 to August 2016, dividends reinvested), or about 4.3% p.a. What would the return have been if we had participated only when the market went up, i.e., if we had avoided every single down month and received a 0% return during that time?
A: 386% total, 10.0% annualized
B: 1,039% total, 15.7% annualized
C: 2,497% total, 21.6% annualized
D: 3,891% total, 24.8% annualized
The correct answer: D. Participating in all the monthly S&P500 gains but avoiding the negative returns would have generated a whopping 24.8% annualized return. $100 would have turned into close to $4,000 (see chart below); move over Warren Buffett! Whether it’s the folks in the FIRE community who are worried about the sequence of return risk, pension funds who have to fund their planned expenses or any other investor: everybody dreads the downside because it has robbed us of 20% of annualized returns recently!
How do we avoid the downside in practice? If I knew how to do this consistently and reliably, I wouldn’t be working for a paycheck anymore. And I would keep that secret to myself and not blurt it out here! Well, there is one way to prevent the downside: buy a put option with a strike price close to today’s index value. Finance lingo geeks would call that an “at the money option.” But that’s going to cost you! You have to pay a premium for that put option. If we look at the diagram below, these are return profiles as a function of the benchmark return:
- The black dashed line is the 45-degree line (i.e., the benchmark itself).
- The blue line is the profile that will get you the 24.8% average return mentioned above: you fully participate on the upside but avoid the downside.
- The orange line is what you’d get when you buy a put option. You get exactly the blue return line, but you shift it down by the option premium. In this example, a little more than 1% of the underlying. We already see one potential problem with this method: you may not lose money on the equity index, but paying the option premium will pull your returns below zero. There is no free lunch: We will never be able to avoid all negative return months!
- The yellow line is the payoff to the person who sold us the Put option.
Why doesn’t everybody buy put options as protection?
Ok, great! Let’s buy put options, hedge out the downside, lose at most the option premium every month but fully participate when the market goes up! If we could get that insurance for, say, 1% per month we still stand to gain 24.8%-12.0%=12.8% on average. Not bad!
Unfortunately, in reality, the insurance is quite a bit more costly. Let’s look at a concrete example. While writing this, I took the following market snapshot on September 21, at around the market close:
- S&P500 future quote 2,155.75 (e-mini contract with a multiplier of 50)
- A put option on this futures contract with a strike price 2,155 and expiration October 21 cost $28.75. Note that both the future and the option on the future have a multiplier of 50. So it would have cost us $1,437.50 (=$28.75*50) to ensure that our $107,787.50 (=$2,155.75*50) worth of equity holdings never drop below $107,750 (=$2,155.00*50) .
- That’s a cost of about 1.33% to hedge the downside for the 30 days. Scaled up to an entire year that’s about 16.2%.
Bummer: That’s pretty darn close to the 20% excess return that the zero percent floor provides. It’s expensive to hedge the downside! And it gets even worse. That’s because right around the time when everybody is looking to buy insurance (2008, 2009, August 2015, January 2016, Brexit in June 2016), Put options become even more expensive. Much more expensive! If you take the average hedging costs over not just the relatively tranquil months like right now, but during all months since 2000 you will wipe out your entire expected equity return. The cost to insure the downside during August 2015 and January 2016 was around 30-40% annualized (!) and it would have been north of 80% annualized (~7.5-8.0% monthly !!!) in late 2008 during the Global Financial Crisis.
Geez, the people who sell put options are getting away with murder. Well, maybe not murder, but definitely highway robbery or racketeering! Who are the put option sellers, anyway? To enter that line of business you probably have bribe some politicians, right?
No! Meet Mr. and Mrs. ERN, put option sellers. It turns out that our brokerage account accommodates both option buying and selling. We will talk about the exact implementation next week, but in our experience, there was no major obstacle in setting up our account to sell options.
Introducing: The least appealing return profile
Of course, some people would argue that selling put options exposes you to the least appealing return profile, see yellow line in the chart above. There is an (essentially) unlimited downside, but only a limited upside. That’s the exact opposite of what everybody desires. But if the average premium is high enough to compensate for the occasional steep losses, who cares? This strategy can still be a winner!
Why the Short Put return profile is actually very attractive to us
I don’t even believe that the put option return profile is that unattractive. As a function of the benchmark return, let’s plot both the put writing strategy return (same yellow line as above) as well as the incremental return vis-a-vis the benchmark, see the diagram below. We can split the diagram into four distinct regions:
- If the benchmark goes down by more than the option premium we will lose money as well, but the loss will be less than the benchmark loss. The put premium cushions the loss. Not very pleasant but better than losing as much as the benchmark.
- If the benchmark goes down by less than the option premium we do the happy dance! We make money while the benchmark lost. We actually hedged the risk in our other equity investments. Woo-hoo!
- If the benchmark is up, but by less than the option premium, we beat the benchmark. Yay! We are definitely happy campers!
- If the benchmark goes up by more than the put option premium we make money, though less than the benchmark. Is that a problem? We have tons of retirement account money invested in stocks, so it’s not that we’re missing out on the gains, we just don’t fully participate in the rally! We are still happy campers when that happens!
It turns out that in each of those regions I would be sitting pretty happy with my Short Put option. So the talk about how this is the worst possible return profile is vastly exaggerated.
Show me the money
How big is the premium in practice and how much return would we make if we consistently sold put options for the last 30 or so years? I consulted the CBOE who put together an interesting fact sheet and a research white paper about this strategy:
- $1.00 invested on June 30, 1986, would have grown to $16.42 by January 29, 2016, if using the option writing strategy. Investing in the S&P500 your portfolio would have grown to only $14.83 (dividends reinvested). Despite selling the equity upside, writing puts would have returned more than the equity index. That’s how overpriced put options are. We say it again: it’s legalized highway robbery!
- Exhibit 18, Page 9 in the white paper: Despite beating the S&P500’s compound return (10.16% vs. 9.85%, annualized, compounded), the put writing strategy had a lower volatility: 10.16% annualized (based on monthly returns), compared to the S&P’s 15.26%. So, the risk-adjusted returns of the put writing index was significantly higher: A Sharpe Ratio of 0.67 vs. the S&P’s 0.47. You get the same return for two-thirds the volatility. Sweet!
Markets are efficient. Then why should any of this option-writing business work?
Efficient markets are the reason why this works. When you sell puts you voluntarily subject yourself to the most undesirable and unattractive payoff profile possible: limited upside and unlimited downside potential. The exact opposite of what everybody wants. The efficient market compensates you for taking losses when they hurt the most.
Why is there not more supply of downside insurance? Nobody has the stomach anymore. Big institutional investors, like pension plans, are actually net buyers of downside protection. If you work for a pension fund or endowment you have a great aversion to downside risk because one big drawdown is all it takes for you to lose your job. Career risk for money managers creates demand for put options. I don’t have that career risk because I manage our own money. I’m not going to fire myself!
Banks face a lot of regulation and can’t afford to take on more risk and drawing the regulators’ scrutiny for a few percentage points of extra return per year. Hedge funds and private investors with a long-term focus and a stomach to sustain temporary short-term losses (and an understanding spouse!) seem to be the typical investors pursuing our strategy.
More information
Other bloggers have written about writing options, (both covered call writing and put shorting):
- Amber Tree Leaves wrote a nice intro piece and also features interviews with other bloggers who write options. Including one interview with Mr. ERN.
- Investment Hunting is trading options and has a nice intro piece about the topic
- Fritz at Retirement Manifesto has a nice piece detailing his option writing strategy
- I’m sure I forgot a bunch of them, please let me know if I omitted anybody!
I also found the podcasts from the Options Industry Council very interesting, see the ones titled “Selling Puts.”
Also, check out the second part of this series. Passive income through option writing: Part 2: How we actually implement our options trading strategy.
Conclusion
Equity investors are compensated for taking on risk. You deserve a higher expected return from your equity portfolio than from a CD or money market account. But that compensation for taking on risk is exclusively for the downside. Investors who have no stomach for losses and only want capital gains are asking for a return profile that’s essentially a lottery or casino-style payoff profile (small premium and large potential payoffs). It shouldn’t come as a big surprise that the expected return of such a strategy is also sub-par: just like in the casino.
Given that the average premium for this downside protection is actually quite rich, selling the insurance should be a good way to generate passive income. We have been doing this successfully since 2011. Simulations going back to 1986 also look very promising! After detailing our philosophy and confirming that this kind of strategy actually works in practice, let’s dive a little bit deeper into what exactly we are doing in next week’s post. Stay tuned!
Nice intro. I look forward already to part 2.
Thanks! Stay tuned until Wednesday!
Also looking forward to finalizing the interview on option trading for your site!
Have a Great weekend everybody!!! 🙂
Cheers
Do you like covered call ETF’s?
No. Covered calls is now a very crowded space, so the “alpha” isn’t that high anymore. Add to that the ETF fees and you’re better off staying away.
I prefer the shot put writing, but with way Out of the money strikes. Still good premium income relative to the risk.
Great explanation, ERN! Also looking forward to Part 2.
Any thoughts on coupling your strategy with trading the VIX (probably VXX)? For instance, the option writing strategy you outline would, I think, tend to perform best (worst) during periods of peak market instability (stability), when VIX is highest (lowest). Possibilities for protection from the “massive downside scenario” with something like this? Just curious – admittedly haven’t given all this too much thought, but it popped to mind as I read your piece.
Nicely done as always! Thanks!
Great question! Very thoughtful!!!
It’s always the cost of protection that’s going to getcha. Going long the VXX is prohibitively expensive. The 5 year chart looks like the VXX went down 99%. Yup, -99% return in 5 years. You have massive contango in the VIX futures term structure and you constantly lose money when rolling to the next month once the current contract expiration gets closer. So much so that I would consider shorting the VIX (either the VXX ETF or the VIX futures). I prefer shorting the weekly put options, though. I get 52 independent bets per year. Only 12 bets with the monthly VIX futures.
But I’ll think about it more and maybe write something in the future.
Cheers!
Thanks, ERN! Makes perfect sense. I thought about it some more and realized there could be some other problems, but your reply here is a better counterargument than what I came up with. Thanks for the helpful reply, and thanks for getting me thinking about this topic – an area I probably need to dedicate a bit more drinking time to!
Awesome! Good luck! 🙂
This is a really interesting post. I’ve read this post over the last three days over and over again trying to digest it and really understand. I’ll probably need to further review but it definitely looks like an interesting strategy in order to create passive income.
Isn’t this just another version of the gambler’s fallacy? https://en.wikipedia.org/wiki/Gambler%27s_fallacy
You’re expecting future volatility to be like past volatility when selling puts. What happens when there is some randome event. Also, isn’t this one of the main reasons LTCM lost so much money and had to be bailed out? Quoted from here – https://econ.duke.edu/uploads/assets/dje/2001/prabhu.pdf
“LongTerm [Capital Management] took the position that historical volatility in the equity markets was an accurate indicator of future volatility. However, oftentimes their traders found that options traded at a
price, which according to the Black-Scholes formula would imply a volatility well above the
historical volatility of the underlying. The explanation that LTCM came up with for this
divergence was that there was a greater demand for options than there was a supply. LongTerm
felt that many investors, who were perhaps unsophisticated, were eager to obtain
insurance for their portfolios, and therefore bid up the prices of equity options. According to
the Black-Scholes formula, the volatility of the underlying asset and the price of an option on
that asset are directly correlated. Therefore, increases in the prices of options due to the high
demand for these securities were implicitly increasing the volatility implied by the options
prices. Long-Term therefore sold options, which meant that they were implicitly selling
volatility, a commodity that they believed had become overpriced.”
“Value-at-Risk models used by LTCM rely on historical data to project
information about future price movements. These models project the probability of various
losses based on the prior history of similar events. Unfortunately, the past is not a perfect
indicator of the future. On October 18, 1987, for example, two-month S&P futures contracts
fell by 29%. Under a lognormal hypothesis, with annualized volatility of 20%
(approximately the historical volatility on this security), this would have been a –27 standard
deviation event. In other words, the probability of such an event occurring would have been
10 raised to the -160. This is such a remote probability that it would be virtually impossible for it to happen. Similarly, on October 13, 1989 the S&P 500 fell about 6%, which under the above
assumptions would be a five standard deviation event. A five standard deviation event would
only be expected to occur once every 14,756 years. There are many other examples of
abnormal market events happening with greater frequency than these models would lead one
to expect. It would appear then, that lognormal models for expected returns do not fully
account for these large losses, and that prior estimates of volatility may not be able to
accurately predict future price movements. This reliance on a risk model that tends to
underestimate the probability of large downward movements in securities prices may have
led Long-Term Capital to be overconfident in its hedging strategies.”
Good point. Put options might be pricing in an event we have never seen in 100+ years. Hence the excess premium. I can’t prove that they are not and you can’t prove that they are. A similar argument, by the way, is sometimes used to justify the (Mehra and Prescott) equity premium puzzle: a catastrophic event we haven’t observed yet. I personally believe that for the put option premium there are fundamental reasons for the premium (myopic investors who have to hedge no matter what the price may be).
For what it’s worth, some responses to the issues you mentioned:
A 3x leverage out of the money put would have fared not too badly in 1998 according to my simulations. Whatever sank LTCM, a short leveraged put wasn’t the sole reason. At least not at 3x leverage.
LTCM went under for a number of different reasons. The bet that had the biggest leverage was the on-the-run vs. off-the-run Treasuries. I think they levered that up by 30 to 1. I heard 100 to one but forgot the exact reference.
Another reason for the LTCM failure was the illiquidity of the convergence trades where they couldn’t get out of their big positions without impacting the price. With my 16-20 short puts I will never get too big for the market.
Another reason is that eventually LTCM got desperate to borrow money from some of the Wall Street players. Bad idea: they didn’t get the funding and in the end the same banks bet against LTCM, which made the mess even worse. Another problem I don’t plan to have. 🙂
As I tried to convey before: 3x leverage does not mean that a 29% drop gets close to wiping out the portfolio. Leading up to the big events in 1987, 1998, 2008 implied volatility was already very elevated when you sold those of the money puts. The 3x leverage doesn’t begin until you hit the strike price, significantly below the current price.
On top of that, our marginal tax is over 35%, so the after tax leverage is actually less than 2.0.
Can you explain the last sentence: “On top of that, our marginal tax is over 35%, so the after tax leverage is actually less than 2.0?”
Thanks for the followup reply. I agree with your counter argument and think people need to be absolutely aware that this isn’t a “free lunch” investment where they can lever up 10 or 20x on a short put. People do outlandish things thinking there’s “no way” for this investment to lose. You’ve done a good job outlining one instance where your investment went bad. It would be nice for you to post a writeup of how the 3x short put would have done in ’87, ’98, or ’08 (maybe even versus a 1x and 5x).
Great work on the blog so far! The amount of time that it must take you to make those nice figures alone makes me wonder if you’ve got a staff working for you.
Oops, hit the reply button too early, while still typing.
Thanks for the compliment! Yes, I got people working for me at the office, but it would be unethical if I have them work on the blog, though, 🙂
Regarding the drawdowns in the years you are interested in, the caveat here is that I have clean option pricing data only since 2003. Before then I would have to make assumptions about the shape of the vol smile curve (how much does implied vol go up whe you go more and more out of the money with your Put options). Before 1990 I don’t even have the VIX, so I would have to deduce that from daily return vol.
with all the caveats: a 3x Put option as described in my other post would have done as follows:
2008: you would have lost money in the weeks ending 10/10/2008 and 5/23/2008. In both cases the 3x option strategy would have lost less than the index. -9% in October, vs. -18% in the index. -0.1% in May vs. -3.5% in the index.
That’s because the strike price was so far out of the money.
Intriguingly, in the week of the Lehman failure you would have lost no money on a Friday to Friday basis. You would have lost on that Monday 9/15/2008, just because the time value went up. But all puts would have expired worthless and you would have made the max premium.
Other years to follow soon…
How are you calculating strike price as a function of leverage for these calculations? Thanks!
Bump
Huh? 🙂
I was wondering how you were calculating strike price as a function of leverage for these calculations. Thanks!
Good question. I normally target a certain yield on the option I sell. If I do 2x leverage (as I do right now) I would seek 5-7% annualized yield for the option. With less leverage you would probably need a higher yield. So, there isn’t a strict formula from leverage to strike price. More like leverage -> target yield. And then look up from the option screen which strike gives me that yield.
So you are defining 2x leverage as the option that would return 5-7% annualized? That doesn’t sound right. Above, you wrote “in both cases the 3x option strategy would have lost less than the index. -9% in October, vs. -18% in the index. -0.1% in May vs. -3.5% in the index.” How did you select the option to sell in order to be at 3x leverage?
There is no 1-for-1 linear relationship between leverage, index return and option return. So, I’m not sure what you mean by “That doesn’t sound right”
5-7% annualized yield is for the unleveraged option. If that’s your target you simply sell the option that delivers that target yield: premium/strike/time2expiration where time2expiration is the time measured in years, e.g., 1/365 per day.
Let me back up to here. You write “if I do 2x leverage…” How do you do 2x leverage? For hypothetical purposes, suppose you have a $100,000 position in SPY, and suppose SPY is currently trading at $250/share. Thanks for your patience!
For shorting options the math is a bit different. If you sell a put option at 2700, and the multiplier is 100x, then you have $270,000 at risk. If you have $135,000 in your account then this would be 2x leverage.
1998:
during the volatile weeks in 1998 from late July to early October you would have lost only during that first week ending on 7/24/1998. (This with the caveat that I have no option data, but rather have to deduce how far out of the money I would have sold the options, considering the VIX level at the Friday close. I’m not even sure they had weekly options back then)
Options were far enough out of the money to avoid a deep drawdown even that week: -1.5% even at 3x leverage. In the weeks following you would have made the maximum premium. With the VIX around 40 you should have been able to sell the puts 10% out of the money, according to my “vol smile model”
So, 1998 was a year when this strategy worked really, really beautifully.
1987, October
Quite an extraordinary month, because the options strategy lost money three weeks in a row. Normally, a large loss one week sends the VIX up high enough that the strike price for next week is so far out of the money, it would be unlikely for the SPX to fall below 2 or even three times in a row.
In the weeks ending on the 9th, 16th and 23rd of October 1987, the index went down 5%, 9%, 12% and the option strategy 2%, 10%, 7%, respectively. It took over a year to recover from that drawdown.
What’s even worse: the intra-week performance was pretty horrendous. You were lucky that on 10/16 the SPX dropped by 5%, so you should have been able to sell the put options about 10% out of the money. But when the market dropped by 20% on 10/19 you still lost 30% with your 3x options. The recovery later that week brought your loss back to single digit percent, but the risk was that you lost you nerve during the rout on Monday and missed the recovery on Tuesday and Wednesday (10/20 and 10/21).
So, yeah, I’m the first to admit that October 1987 doesn’t look good. The one piece of good news is that these kinds of events normally don’t occur out of nowhere. There is usually some volatility and fear building up beforehand so you can sell at strikes far, far out of the money.
Nice work there! Thanks for the thoughtful response.
No problem, thanks for your thoughtful comment!
Just stumbled upon your blog and this extremely interesting. Over to part 2 and then the rest of your site.
Take care!
Colby
Great! Thanks for the compliment. Enjoy the ride!
Cheers,
ERN
I’ve been thinking of doing something similar since growing my sophistication enough to put in limit orders well below current market price so as not to miss a flash crash because I was too busy working or playing.
Selling puts would be essentially the same thing, wouldn’t it, except that I’d get paid to provide that insurance for others?
I think what kills put sellers is Rho, or the 1st derivative of vega. In other words, the put you sold may increase in value with a tiny move down in future price. Then a large drop in the future and losses can become catastrophic, even with a small position.
Not sure I agree with that 100%. The price of the option converges to the fundamental value over time. If you sell short enough options with not too much leverage you don’t have to worry too much about this.
Also: the option rho is the derivative with respect to the risk-free rate.
Hi Ern,
I’ve been reading these blog post so many times I’ve lost count. I’m trying to replicate the strategy using a paper money account in IB and realized I don’t fully understand how to chose the strike price for different levels of IV.
From what I’ve understood you look at the following:
1. Time value (p.a. ~7%)
2. Delta (3x delta should be less than 0.5)
3. Number of standard deviations OTM
4. Implied volatility (IV>VIX?)
What is the driving factor that makes you chose a particular strike price for your puts? Do you always chose options that has a time value ~7% or options with IV based on ask price > IV for option, etc.., or is it a combination of above? Are there weeks when you believe that the options premiums are not rich enough to warrant the risk, and if so, how do you determine this?
Thanks for the excellent write ups and a great blog!
That’s roughly correct. I’ve shifted a little bit now that I’m retired and like to take less risk:
Time value ~5% p.a. (unleveraged)
Leverage around 2-2.5x
Delta around 0.05-0.10 (unleveraged)
About 1-1.5 sigmas out of the money
IV vs. VIX is something I look at, too. But due to the different horizon there is a mismatch, so take the IV vs. VIX with a grain of salt.
I always sell puts, but if the premiums are not that rich then so be it. If the put with a 5% yield has a strike not far enough out of the money I’m willing to sell a lower-yielding put.
What is time value 5% p.a.?
Time value is the value of the out of the money option.
p.a. = annualized
5% annualized time value would mean roughly 0.1% of the notional (=S&P 500 index), so roughly $2.70 for a weekly option.
Hope this helps!
Thanks for your reply!
If I get it correctly you are mainly using option selling as a means to control risk and reduce the sequence of return risk compared to a strategy holding mainly stocks and bonds.
Do you see a value for a person which is roughly 1/3rd towards his fire goal to diversify his portfolio with option selling as well? The main benefits I could think of is leverage and slightly better gains compared to index investing (is this really the case?). Is there anything else that I’m missing? I don’t care too much about taxes since I’m currently residing in Hong Kong.
Yes, I see a value for people pre-retirement. If you’re far enough along you’ll suffer from Sequence Risk, even as a saver, see my recent post on this:
https://earlyretirementnow.com/2019/01/23/crash-good-for-investors/
That said, I don’t believe that “better gains” is really accurate. I’d call it “better risk-adjusted gains,” so it’s (hopefully) similar gains with a lower risk. Or slightly better gains with still lower risk.
Hi ERN, was checking the cboe.com indices returns from June 30, 1986 to January 29, 2016.
S&P 500 = 9.5% annual avg. / Put Write = 9.9% annual avg. with less volatility as you pointed out. Just thinking though that, for me, with the extra work involved in implementing a put/write strategy, time, stress, and my hesitation to use leverage risk at my point in life, and maybe only comfortable with allocating $200k to Put Write strategy, that would be .004 x $200k = $800 extra per year pre-tax (deferred in an IRA, but not avoided permanently) for me…..hmmmm…..I guess it would be an intellectually stimulating activity during my retirement…:)
Well, let’s keep in mind a few items here:
1: It’s a better return at a lower risk. That is worth something, especially for retirees who fear drawdowns (i.e., sequence risk).
2: The plain CBOE put writing strategy doesn’t involve much work . One trade every month.
3: You can enhance the expected returns a little bit more by holding your mrgin cash in Muni Bonds. You get a higher yield and it’s tax-free and you even get a bit of divirsification benefit through a slightly negative correlation with the equity beta.
The links to CBOE’s fact sheet and white paper are no longer active. Might you know where those moved to?
Thanks for letting me know! I updated the links. Check if they work for you! 🙂
Please ignore. I’m not sure how to subscribe to the comments besides making a comment so that’s what I’m doing.
Did you use this strategy in 2020? I would like to know what the result was. I would imagine selling puts during the March plunge would have been very costly, but the rest of the year profitable.
Yes, see part 4: https://earlyretirementnow.com/2020/06/10/passive-income-through-option-writing-part-4/
Very successful so far in 2020. No losses from put selling in March this year. In fact, March 2020 was the most profitable month ever for selling puts, both in % and in $ terms. 2020 was the second best calendar year so far, after 2019.
Hi ERN,
I recently discovered your blog, and must say I really enjoyed the mathematical and statistical approach you take to explain your thoughts on different concepts.
What are your thoughts if we were looking to implement a put writing and/or covered call strategies on index ETFs if we didn’t have access to future markets in particular:
1. The “Wheel” on an index ETF such as SPY, VOO, or VTI where you start off writing naked puts. If your put is ITM at expiration and you’re forced to buy 100 shares, selling covered calls until your calls become ITM and reverting back to puts.
2. Buying a covered call ETF or replicating it’s strategy with your own adjustments.
Hope to continue devouring your content (at 10+ articles read a day this last week).
You can easily replicate this with put selling on ETFs and in any asset class you wish.
I don’t like the wheel. It can backfire if/when the drawdown is long (e.g. 2001-2007).
See Part 4 of this series in the section “Why not just keep selling puts at the last strike at which you lost money?” 🙂
Thanks for the answer! Have a good July 4th weekend.
Link to CBOE research paper seems to be broken. Is this the paper? https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2750188
Thank you
Thanks for the updated link! 🙂
Question on this:
“There is an (essentially) unlimited downside, but only a limited upside.”
Not sure if I am missing something here, but selling puts only has a max downside of all the shares you’d owe at strike, minus premium you got right?
It’s not like selling short where your downside can be infinite?
Correct. Thus, the qualifier “Essentially”. Your downside is limited to the strike times the multiplier if the index were to go to zero. Highly unlikely, of course.
What do you think of selling deep OTM covered calls to supplement retirement income? It looks like I can sell 30% OTM calls a year out for about .3%, a solid improvement to the 3.25% SWR. The downside only happens when the stock market rises 30%, but that is not the situation that makes the SWR so low anyway.
Interesting idea.
The only question: what happens when you did that at the bottom of the stock market in March 2009? You would have seen a 70% recovery over the next year, and missed out on 40% of gains.
There’s no free lunch.
But generally, sounds like a promising route.
What are your thoughts on Poor Man’s Covered Calls (PMCC) (Diagonal Call Spread)?
You buy a deep ITM LEAP and then sell really small-DTE OTM calls throughout the life of the LEAP (roll the LEAP as needed, probably when the delta gets under 70 or so).
In an efficient market, this should work right? The deep ITM leap is essentially a leveraged buy on SPY, the ITMness and large DTE minimize the Theta decay. It should be a cheap form of leverage?
While selling small-DTE OTM calls does the opposite, it maximizes the profit from theta decay.
Intuitively it makes sense in that if the best calls to buy are deep ITM LEAPs, the best ones to sell would be the complete opposite: small-DTE OTM calls.
I wonder how this would be vs a box spread. It’s not delta neutral but that should be an advantage?
I like the idea. It serves two (related) purposes: risk control and it helps with margin constrains, too. You give up a bit on the premium, though.
But I like to do this more on the put side. The premium is more attractive.
I probably missed this somewhere, but how do you determine whether or not to buy back the contract if it is in the money versus letting it be assigned?
At the time of writing this particular post, I just let them expire ITM if need be. But I’ve since shifted to using stop-loss orders. See Part 10 of the series. Published on Jan 9, 2022.
Thanks for writing about this and the Box spread. Almost all other sources, including the famous Options, Futures, and Other Derivatives by Hull, neglect to mention these reason to sell puts (selling insurance) or sell/buy a box (to borrow or lend). Textbooks misleadingly imply that the main reasons to trade options are arbitrage or to meet some cash flow need for a large corporation.
Excellent point. But in defense of the industry, the gap between realized and implied vol is well-documented. So, one has just to put 2+2 together and run with it.
About the box spread, that was brought up by a reader. I don’t remember hearing about it before. Sometimes, you learn more from running a blog than from studying this stuff. 😉
Hi Karsten,
While reviewing your selling put option strategy, I noted a broken link.
The Option Industry Council podcast “Selling Puts” can be found here:
https://www.optionseducation.org/podcasts/intermediate
And the fundamentals about option can be found here:
https://www.optionseducation.org/podcasts
Great source of knowledge there!
Thanks again!
Thanks for letting me know! Will update those!
Thanks for the write up. Can you help me understand
1) What is the expiration for the put write ? 1 month out ?
2) How much OTM is the strike ? 10% ?
3) What is the underlying ? SPY ?
4) The better return profile is when holding equity + write put vs holding equity only, correct ?
Back in the old days I indeed wrote month out. Then 1 week (Friday to Friday). Currently, I write every day with 1D to expiration. And most of the time also intra-day, i.e. at market open expiring that same day.
I use varying OTM targets, but usually about as much premium target as I need for my retirement budget. Sometimes as little as $0.10 premium, sometimes $0.50 per trading day.
SPX options (100x) at the CBOE.
The better return profile is the SPX put writing. It can go on top of any other portfolio, not just equities. In fact, with too much equity risk, I’d not want to write a lot of downside insurance. I know folks who do this on top of a pure cash portfolio (IB currently pays, I believe Fed Funds Rate minus 0.50%). So, ~5% interest plus another 5% from put writing is not a bad deal for a mostly low-vol portfolio.
thanks for your quick reply, appreciate you sharing your knowledge
on #1 & 2) just as a ref – to get $12 premium after commission (per contract), the target SPY put is 1% OTM for 1 day and ~4% for 1 week
on #4) Can you help me understand this: “$1.00 invested on June 30, 1986, would have grown to $16.42 by January 29, 2016, if using the option writing strategy. Investing in the S&P500 your portfolio would have grown to only $14.83”
a) Is a “pure play put writing” strategy beating a “pure play equity” strategy ?
b) What is the option write duration and % OTM here ? I find the “pure play put” beating SPY non-intuitive because with the numbers above (daily put write 1% OTM, $12 per contract, I get ~5.2% annual return on a base of SPY price $458. Of course, the put premium is super cheap now, so let’s say that is 50% higher – even then, returns are ~8%).
c) For all this – one is taking on a risk of cash covered assignment at only 1-4% discount. So I don’t understand how this strategy beats SPY in long run. Maybe my assumptions are incorrect
First: I don’t trade SPY. Only SPX. Premium targets for SPY are meaningless for me.
The %OTM changes everyday. So, I cannot make general statements. It all depends on the IV that day. Last week I get 0.10 premium on day 0.40 for the same OTM%.
$1.00 would have grown to $x after 30 years means exactly what it says. You track the total return of the two strategies.
a) Again, we can’t make general statements. If you lever up the options writing strategy you can get higher average returns than the stock market. But normally, I target only a small alpha. The CBOE index that did beat the index was using a 50-delta (ATM) put with 1-month duration. The cash was invested in 3M T-Bills.
b) Currently 1 day.
c) keep in mind that the puts are sold on margin and you can still invest the margin cash and earn return on that too. So, you’re comparing apples and oranges when you compare the 4-5% put premium return with a fully funded equity portfolio.