All Parts of this series:
- Part 1: Intro
- Part 2: The strategy as implemented in 2016
- Part 3: Some updates on the strategy as I’m currently running it as of 2019
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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 …
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.
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 option trading strategy.
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!