Last week we made the case for generating passive income through option writing. A quick recap of last week: buying puts to secure the downside of your equity investment is a bit like casino gambling: pay a wager (put option premium) for the prospect of winning a big prize (unlimited equity upside potential). Unfortunately, the average expected returns are also quite poor, just like when you gamble in the casino or buy lottery tickets.
Since we can’t beat the casino, let’s be the casino!
Being the casino means we act as the seller of put options. Let’s see how we implement this:
- Brokerage account: we use Interactive Brokers. It seems to be the cheapest provider in terms of per contract trade fees, but they also nickel-and-dime us with all sorts of other small fees. Given the large volume of contracts we trade every year, we currently bite the bullet and pay those nuisance fees knowing that we save a lot on commissions. But if anybody has experience with other providers who charge lower fees (IB: currently $1.41 commission per futures option contract) please let us know.
- Underlying: we want to sell a put option, but on what? Currently, we sell put options exclusively on S&P500 futures contracts, specifically, the e-mini contract (ticker “ES”). It sounds really scary: we sell a derivative on a derivative. A derivative squared! But economically, this is almost indistinguishable from selling put options on, say, an S&P500 index ETF. But: There are a number of advantages when we implement the put writing strategy with futures options rather than options on equities or ETFs:
- We can run a tighter ship with our margin cash. Selling a put, you face the possibility of having to buy the underlying at the put option strike price. If you are forced to buy a large chunk of equities or ETFs it’s better to have that cash available and ready. Otherwise, you face paying margin interest if your cash balance drops below zero. But we don’t like a lot of idle cash sitting around; remember our theory about emergency funds?! Everything is much easier with futures contracts because they don’t require any cash outlay (except for a small cash margin cushion) and they are extremely liquid and cheap to trade. We are able to keep around 70% of the margin cash in a municipal bond fund to generate extra (tax-free!) interest income. We also found that the bond fund serves as a diversifier: When equities go down, bonds do well. And with a 70% bond weight, it’s actually enough of a bond weight to make a difference in terms of diversification!
- Tax season is a breeze: we trade about 16-20 contracts a week, or 800-1,000 per calendar year. If we had to keep track of all trades and itemize them all on our tax forms it would be taxmageddon every April 15. But since options on index futures are considered Section 1256 contracts for U.S. tax purposes we have to report only one single number on tax form 6781, line 1: the net profit/loss of all such contracts combined. Everything is already net of transaction cost. I spend more time documenting my 2-3 mutual fund trades on our capital gains tax forms than our 800 to 1,000 option trades! Moreover, all profits from our option trading are automatically considered 60% long-term capital gains and 40% short-term gains, irrespective of holding period. Sweet!
- Account size: we currently run this strategy in an account worth around $500-600k. I personally started with $30k of play money just to learn my way around but then eventually grew the account once I felt more comfortable. We like to short one put option for each $30-35k of account size. So that $30-35k would be the minimum recommended account size.
What option(s) do we short?
Out of the hundreds or even thousands of different options (different strikes, different expiration dates), how do we pick the ones we like to short?
1: Picking an expiration date
We pick the shortest possible time to expiration. That means every Friday we sell a new set of put options expiring in exactly 7 days. Then, next Friday we sell the next round. We like to keep the maximum number of independent bets because that’s how casinos make money; when the house has an advantage the more people play and the longer they play the more certain it becomes that the house wins!
“In the casino, the cardinal rule is to keep them playing and keep them coming back. The longer they play, the more they lose. In the end, we get it all.” Sam Rothstein (Robert DeNiro) in the 1995 movie Casino
2: Picking a strike price
Even though we initially introduced the put writing strategy as selling at-the-money puts, what we do in practice is slightly different. Here’s a snapshot I took last week on Wednesday (about half-way through the trading day). The ES future was sitting right at 2150.00. You could sell an at-the-money put for $15.75. For the roughly 9.5 days to the expiration that would mean a whopping 28.15% annualized yield. Remember from last week: hedging out the downside gives you “only” about 20% p.a. extra return! So, option premiums are quite rich, especially at weekly frequency! But we also include the puts that are out of the money. You can find strike prices in steps of 5 points, but we list only the strikes 2,075-2,100 in steps of 25 to save space.
The option with strike 2,100 looks most attractive to us (note we didn’t actually trade any of those on Sep 28 because we still have the options expiring on Sep 30, so this is just a theoretical exercise):
- It offers a decent yield of 7.33% p.a. (= option premium as % of underlying index, annualized). Note that this is the gross revenue if the option expires worthless. Every once in a while you lose money on the trade and our long-term average experience has been that we keep about half of the option premium as profit and pay out the other half to the option buyers. During the very calm periods (parts of 2012, all of 2013, the first half of 2014) we actually kept close to 90% of the gross option premium. But that’s not typical; during the last two years, with volatility and significant drawdowns, half of the gross revenue is all we got. We will have to use leverage to get to our desired expected return level.
- It’s far enough out of the money that we have enough of a cushion against losses; the S&P can drop by around 2.5% and we still wouldn’t lose money. We like that kind of wiggle room. When you sell put options at the money the premium is higher, but even the first dollar of a decline will already eat into your profit!
- The implied volatility is about 14.5%, higher than the prevailing market-implied volatility (VIX) level of 13.2%. We like that! Is has been documented that, in average, the VIX is higher than realized volatility (see page 3 sidebar table in this paper), and if our option has higher implied vol than the VIX we have two cushions:
Option Implied Vol > VIX > Realized Volatility
3: How much leverage?
We use leverage for two reasons:
- To compensate for the impact of marginal taxes on investment income we like to scale up by at least a factor of 1/(1-tax rate).
- For the same reason leverage is normally used: boost an attractive return. Shorting only one single put option per notional value of the ES future ($2,150 x 50=$107,500) would create too little return and very little risk as well. At the inception date, the short 2,100 strike option had a delta of 0.15, so it is only 0.15 times as volatile as the underlying index future. We can “safely” scale that up to 3x leverage and still maintain less volatility than the underlying, most of the time.
How much more risk comes from leverage? Last week we pointed out that with the simple short put option without leverage you would never lose more than the underlying. That changes once you introduce leverage. In the chart below we plot the payoff diagram of the 3x short put option:
- In region 1 we lose more than the index. But it’s still not 3x the index loss. Even if the index were to drop all the way to 2,000 (-7%) we lose about just over 13%, not 21%. That’s because the 3x only starts after we drop below the strike price. Because of this cushion, our strategy will actually look less volatile than the index, most of the time. Only under extreme circumstances would we face more volatility, see case studies below.
- In regions 2, 3, and 4 we beat the index. Sweet!
- In region 5 we make money but less than the index. Again, as pointed out last week, we are not too concerned about this scenario because we have plenty of other equity investments, so our FOMO (fear of missing out) is not too pronounced.
Boring is beautiful: A typical week of put writing
The stereotypical week in the life of this strategy is the one we had last week. Here’s the path of P&L for the 3x leverage Short Put vs. the simple index investment (through the S&P500 index future):
- September 23 midday: sell 3 put options, strike 2,110, while the underlying was at 2158.00.
- September 23, market close: the ES future closed at 2,158. Our P&L was about very slightly down. (Volatility went up a little bit before market close, hence the increase in price, despite an unchanged underlying!)
- September 26: the ES contract closes down at 2,139.75, almost 1%. Bummer, that’s a bad start to the week. Our position lost money but less than the underlying. We were still far enough away from the strike, so nothing to worry about (yet!).
- September 26-29: the ES contract recovered from its “bad case of the Mondays” and bounced around between 2,148.50 and 2,163.25. Our short options roughly mimic the path of the equity future P&L.
- September 30: the ES contract closes at 2,160.50. That’s above the strike price and we made the maximum premium. We are slightly ahead of the equity index for the week!
With the exception of a small scare on Monday, this was a very uneventful week. We earned the maximum option premium, while equities bounced around quite a bit. Despite the equity volatility throughout the week and our 3x leverage, it was a smooth ride. We had less volatility than the underlying index and made more money. Making money the boring way, one week at a time!
Murphy’s Law: when this strategy goes horribly wrong
OK, for full disclosure: put option writing with leverage is not for the faint-hearted. Sometimes things can go wrong and when they do one can lose a lot of money in a short time. I am fully aware of this feature and believe that this is the cost of doing business. To use the casino analogy again, sometimes a slot machine pays out a big prize. If it didn’t, nobody would want to play it.
Let’s look at what happened in the first week of January 2016. We had initiated a bunch of short puts on December 31 (Thursday because Friday was a holiday). Even between selling the option and the closing that day, the index future dropped, though not by much. For the first few days in the new year, the index kept going down and we mimicked that path, though our losses were actually muted despite the 3x leverage. That’s because if you are still far away from the option strike price then you still have that “cushion” and the volatility even in the 3x leverage short put portfolio is muted. (For finance nerds: The option Delta is still far below 1!)
But then came Thursday, January 7: The index dropped by 2.4% and our P&L went below the index. Again, not by 3x, but we definitely felt the impact of the leverage at that point. On the Friday exit, the index dropped further, though we had the wisdom of pulling the plug and closing the position while the ES Future stood at 1,928.50. Wow, what a ride! Instead of making $405 with the three short puts (2.70 x 3 x 50=$405.00), we lost over $7,000. The portfolio lost a lot more because we had a total of 20 short puts (some at better strike prices with lower losses, though), but the damage was done. We had the worst start to a new year ever! It would take until mid-March this year to just get back to zero return, and even that was aided by the excellent returns in the Muni bond fund. Considering only the short put strategy it took 18 weeks to dig out of the hole!
When this strategy goes “horribly right” – Yhprum’s Law
Meet Yhprum (a second cousin of Murphy) and his law applies when, for a change, everything that can go wrong actually goes right. I have had a few instances of Yhprum, most recently around the Brexit mess in June 2016. Let’s look at the week of June 17-24.
There was a pretty bad drop on June 24, but we still made money. That’s because the uncertainty about the Brexit was already reflected in the option prices on June 17. Thus, we were able to sell put options with strike prices so far out of the money that even the steep decline on June 24 never got even close to causing any losses. In the P&L chart below, note how between 6/17 and 6/23, the P&L of our strategy and the index have a positive correlation, but our movements are very much muted. Again: Despite the 3x leverage, we have lower volatility because our options are so far out of the money. Then comes Friday 6/24. The S&P index drops by 3.6%. The ES Future goes all the way into the low 2,000s. That wouldn’t harm us because our option strike was at 1945. We actually made a small profit that day. Despite 3x leverage! And in case you wondered: the post-Brexit week was also profitable: on 6/24 we were able to sell puts with strikes in the 1,800s, because everybody got so scared on Friday. On Monday the market dropped again, but then recovered swiftly and we earned the full option premium that week as well.
Returns over the last two years
Case studies are fun, but what was the average performance over the last year or two?
The last two years have been a tough environment for equity investors. The second half of 2014 was volatile, and 2015 saw the mess with the Chinese devaluation and a Federal Reserve rate hike. January and February of 2016 were pretty awful, but we did reach new all-time highs in August. But the path was very bumpy (did I mention the Brexit?) and the average equity return was 6.8% from September 30, 2014, to September 30, 2016, with dividend reinvested. That’s still a decent return but less than the long-term average.
Our option writing strategy performed significantly better, see chart below. We got an average annualized return of above 15%, more than twice the equity return. In contrast, we had a volatility of only 6.2%, about half of the index ETF volatility.
For full disclosure: our returns include the additional returns from investing in the Muni bond fund, which had excellent returns over this 2-year window, not just interest but also price appreciation. But we want to stress this issue again: The bond returns are part of the strategy because we have $600,000 of cash sitting around, which we should put to use. Also, the returns are net of all the fees and commissions. We don’t expect 15% returns to last forever but 12% before tax and 8.5% after tax with 6-8% annualized risk would be our target return profile.
Our strategy has major drawdowns around the same time as the S&P500. But the advantage of our strategy has been that if additional drawdowns occur after the initial event (September 2015, February 2016), we actually make money. That’s because investors were in panic mode and drove the option premiums up so high that we sold puts at strike prices far out of the money: none of our short puts lost money even when the market dropped further in consequent weeks. Thus, despite our 3x leverage, we had a pretty smooth ride after the initial drop. And, as mentioned above, the Brexit didn’t harm us either!
Last week we introduced the option writing strategy for passive income generation. The run-of-the-mill strategy would be to sell a cash-secured put, at the money. It’s so popular, Wisdomtree even made an ETF out of it. We take this well-known strategy and make four adjustments: 1) leverage, 2) sell out of the money puts, 3) use weekly options instead of monthly, and 4) hold margin cash in longer-duration bonds (not just low-interest cash) to boost returns. So far we have fared pretty well with this strategy, easily beating the S&P500 benchmark. We do have drawdowns, about in line with the large S&P500 weekly losses during the recent stress periods. But the overall volatility is much lower than the S&P500.