All parts of this series:
- Trading derivatives on the path to Financial Independence and Early Retirement
- Part 1 – Intro
- Part 2 – Extended Intro
- Part “2.5” – Trading like an Escape Artist: October 2018 update
- Part 3 – Strategy details as of 2019
- Part 4 – Surviving the 2020 Bear Market!
- Part 5 – A 2018-2020 backtest: Guest Post by “Spintwig” (plus a quick update on last week’s volatility)
- Part 6 – A 2018-2021 backtest with different contract sizes: Guest Post by “Spintwig”
- Part 7 – Careful when shorting long-dated options!
- Part 8 – A 2021 Update
- Part 9 – A 2016-2021 backtest: Guest Post by “Spintwig”
* * *
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:
Implementation:
- 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.
Update (September 2017): For most of the year 2017 we’ve shifted to even shorter-dated options. There are three expirations every week (Monday-Wednesday-Friday). So, now we write options on Friday that expire on Monday, then on Monday, we write options that expire on Wednesday and every Wednesday we write options that expire on Friday. The premiums for the shorter-dated options seem “richer,” i.e., we get the most premium per unit of risk we take on.
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!
Conclusion
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.
Wow I love this strategy and how you’ve detailed it so thoroughly. I’m very tempted to start a small portfolio to play with. Would you have the option to do this through a tax sheltered IRA to avoid the tax consequences?
I’ll be saving these articles for reference later! Awesome stuff ERN, truly awesome.
Oh thanks! Great to hear.
Put writing in futures is probably possible in an IRA but there seem to be some onerous regulations. Interactive Brokers would require you to set aside 3x the usual margin of a taxable account.
So, I run this strictly in taxable accounts.
http://ibkb.interactivebrokers.com/node/188
As I detailed in a previous post, if you are concerned about taxes on the Section 1256 contracts you just scale up the leverage by 1/(1-tax):
https://earlyretirementnow.com/2016/06/07/synthetic-roth-ira/
The after-tax return would be (almost) identical to the return in an IRA.
Example: running the put writing strategy with 2x leverage in the IRA is roughly the same as running it with 3x leverage in the taxable account if your marginal tax on Section 1256 contracts is 33%.
In light of that I would probably advise against the put writing in the IRA. We use the IRAs for our stock investments only.
Cheers!
Awesome post, ERN! Muchas gracias.
Thoughts on selling covered calls v. selling puts? Again, you’re much deeper in this stuff than I am, but my feeling is covered calls would provide a similar overall risk profile while diminishing cash needs (since the “borrowing” would be the equity/index itself). Would this enable superior diversification…? (And I guess you could synthetically lever by selling covered calls against a, say, a 3x ETF or something.) Just a question/thought. This topic area has definitely been long abandoned by my brain – very pleased to benefit from your expertise here.
This is a killer post. Very practical. I’ll definitely have to keep thinking about all this stuff – you’ve made a great case. Thank you for the even-handed discussion, examples, etc.
Have great/safe travels, and thanks again!
Thanks!
Great questions!
Short put vs covered call should have identical payoff profiles if the strikes are the same (put-call-parity). My experience is that there is more liquidity (smaller bid-ask spread, trade volume) in the contracts out of the money: puts with strike current underlying. About the same liquidity for at-the-money strikes.
So for trying to sell deep out of the money downside insurance selling puts is better. For folks who prefer more equity-like payouts who want to sell the upside (say current price +2% and above) going long future and short call is more efficient. But then you shouldn’t do 3x leverage! 🙂
I did notice that short puts require more margin requirement than the corresponding covered call. That’s inexplicable given put-call parity. But that’s what it is.
Regarding ETFs, I still prefer to do this with futures and futures options due to the preferential tax treatment. And for leverage, doing leverage with futures is so much cheaper than with the 2x or 3x ETFs. Also I’m not 100% sure they have very liquid option markets in the leveraged ETFs.
Thanks for the thorough reply, ERN. Much appreciated. Great post – thanks again!
Great post ERN. You have demystified option strategies and have made this DGI guy re-think about his own passive income options. Keep up this great work!
Thanks for the compliment, TFR! Always trying to come up with thought-provoking content!
Cheers,
ERN
I’ve read through a few of the white papers on CBOE, and this is just another awesome tool in the belt of investors/savers!
I love your posts because they’re so cerebral, yet explained thoroughly enough for the novice to grab onto. I’m grabbing onto this string and pulling until I reach the whole ball of yarn. I’ve only recently begun trading futures and options, but have been doing a form of risk parity with leveraged ETFs for 5-6 years now. Going forward I expect some of these new ideas you’ve explained so well to become mainstays in my investment strategy!
Well done, and I look forward to more of your work.
p.s. I saw that you “followed” my own blog on this site (you are now my second follower!) that I [barely] started a few years ago. Indeed, you’ve motivated me to try again with the blog!
Awesome! Thanks for the compliment.
Your comments are always very thoughtful. They are almost their own blog posts, so you should have no problem getting your own blog rolling.
Bets of luck with your new strategies!
Cheers!
ERN
This is such an awesome detailed post. Rationally it all makes sense, but unfortunately it seems like you’d need a pretty big portfolio to cap this at 20% of your portfolio though. And I’m assuming the lower your marginal bracket, the more capital would be required to make it worth the effort. Do you buy and sell at a specific time every week? I assume you are using a Muni ETF rather than a traditional mutual fund, hasn’t there been concerns about liquidity inside bond etf’s?
Thanks!
I currently lever this up by about a factor of 3, but once I reach retirement I would probably do only 2x leverage. So, we’d be talking about roughly $50k in margin per short put. Up from the current $33k. So, as you say, you’ll need more margin per contract when in a lower tax bracket.
I currently sell on Wednesdays and Fridays. The ES put options now have both Friday and Wednesday expiration dates and each Wed I sell new options for the Fri expiration and vice versa.
I am using a muni mutual fund. I’m more worried about rising interest rates than liquidity. I made good money with the muni fund so far, but a lot of the capital gains have now melted away again with the 10Y rate above 2% again. But then again:the Muni fund is for the tax-free interest income. I never budgeted large cap gains for the bond fund.
Cheers,
ERN
Hey there, I’m a new reader (brought in by your excellent recent series on SWRs — thanks for that!) trying to wrap my head around this strategy. A few questions:
1. Based on your description in the last post and this, it seems like the strategy has a higher expected return than the index funds it tracks with similar or lower risk, even accounting for your leverage. Is this accurate (implying the market in this case is less-than-efficient) or is my understanding on one of those points wrong?
2. Assuming that this strategy actually does have a higher risk-adjusted return, any speculation on why nobody has “productized” this strategy into a mutual fund or ETF that executes on it on behalf of investors, without requiring the manual weekly maintenance you describe? Assuming a big trading house *does* notice this strategy, any reason to believe that its returns at that point won’t be driven down to the level of the underlying index?
3. Finally, how much of your time do you have to spend actually executing this strategy each week?
Basically, I’m trying to figure out if it would be worth my time (and the risk of messing something up) to implement this strategy myself, given the relatively small amount of principal I could use to execute on it and the possibility that future returns will revert to those of the index. Thanks!
Thanks!
1: That is correct. So far it has performed better than the index at lower risk. And I expect this to continue.
2: This strategy and its variations are being used. Wisdomtree even has an ETF: PUTW. It does the put writing as described in the CBOE piece. So, the strategy of “selling volatility” is nothing new in the finance world. It’s not so much about if people know about this but more about if people have the stomach for it. My returns have a skewness of -2. Most investors find this completely unacceptable. Pension funds and endowments would never touch this.
3: I now trade 3 times a week (Mon/Wed/Fri) to roll my positions. About an hour on each of the days. Maybe abound 30 minutes in the morning around market open and 30 minutes around market close.
One tip: Try this for a year with a small amount, especially when using leverage. One single contract has a notional of 50x the S&P500, so 50*2,300=$115,000. Even at 3x leverage, you’d need $38,000 margin cash.
Any reason you don’t use SPX? About 2x the size of /ES , high liquidity, cash settled instead of settled into futures.
I will look into trading index options (rather than options on index futures) once I’m retired. Currently, I am subject to trading restrictions at work that require me to pre-clear index option transactions. But I have no such restrictions on futures options. Crazy rule, but that’s the way the world works here. 🙂
Thanks! That makes sense from your perspective. I thought I was missing something with the ES futures. I’ve been running the same strategy for awhile now, levered using SPX. I believe there’s a tax advantage for Americans too on index options.
It’s reassuring to know some other FIRE member is doing this as active management is a bit frowned upon on reddit or bogleheads. Are you selling irregardless of implied vol? With VIX at these levels and the short dated nature of your trades, there is quite a bit of gamma/vega risk.
Yes, both futures options and index options are Section 1256 contracts with preferential treatment under the U.S. tax code!
I agree, at the currently low VIX levels you don’t make much money. All my major losses came when I sold puts at very low vol levels and then out of the blue the bottom fell out (e.g., August 2015). I’ve had one very small loss in early March, so far in 2017. Still a 95% profit on the gross option premium income. My budget is that I keep 45-50%, so I have built a cushion! 🙂
So, to answer the question: I try to time as little as possible.
Would you mind sharing some risk measures you use to monitor this portfolio?
For example, using current implied vol on spx (VIX), we can estimate 1,2,3 stdev moves in the underlying. How does this translate to unrealized losses in the puts? Theoretical estimate using black scholes for jumps in Vega and increasing negative delta? How do you reasonably estimate losses for a 5 delta put vs 30 delta put given many moving dimensions. Thanks in advance
Very thoughtful comment! Thanks!
I keep track of multiple risk measures:
1: Current Portfolio Delta
2: Current Portfolio Gamma
3: P&L of a 1.5, 2.0, and 3.0 sigma drop in the underlying between now and expiration. This is in multiples of the current VIX times sqrt(t), of course.
All those can be calculated on the individual put level (and the P&L per $ of margin cash) or for the portfolio combined.
I also have another spreadsheet where I calculate the impact of scenarios like SPX down by x% and VIX up by y% both instantaneous and with some time decay. But I rarely use that. I find methods 1 (for instantaneous) and 3 (for P&L between now and expiration) the most useful.
Cheers!
This is great work!
Thanks for stopping by! Glad you liked this!
Great article. Thanks for the detailed, concrete examples. I’ve been using a similar strategy for the past 2 months to get my feet wet. I have been writing puts much further out of the money than you, which requires less margin. For example, for a 2100 strike with 2420 underlying, 4 week expiration, one contract required less than $500 of margin. With this approach, I appear to be getting similar returns as you (around 20% annual, after taxes), but I “babysit” it a lot less, since my strikes are so low. Of course, I still keep an eye on the S&P 500 a few times a day, but I don’t care about movements of 50 in the underlying (other than their impact on my margin requirement).
Did you research an approach like mine to reduce the amount of day-to-day churn you have to deal with as the underlying bounces around?
Great article! I want to do the same. Please recommend me. Let me introduce myself a bit.
I am now 38 years old, retire. I live solely on writing options too but only equity options. I have been doing this for 5 years. My favorite underlying stocks are MCD, BRK.B, SBUX, AAPL, AMZN, BABA. But I never try writing options on future. My return is about 15-20% annually. I never trade future before. But after reading, i want to explore more on trading options on future. I want to try doing the same thing that you wrote.
My questions is…I couldn’t find the symbol “ES” on the options trading platform. Will it be on future trading platform? Should I contact my broker?
Great!
I’m trading options on the E-mini S&P 500 Futures contract:
http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500.html
The ticker on the underlying is ES on my trading platform (Interactive Brokers) but you’d have to look up what that would be on yours. It’s a futures contract and you will likely have to get trading clearance first for this asset class.
Best of luck!
ERN
Fascinating post. I love the “be the house” analogy. If I’m understanding it correctly, you are getting better than market returns now. The risk is that if there is a huge market dip in any given week, you could lose huge. Basically, exactly what would happen at a casino when somebody hits a jackpot. What percentage of your portfolio do you risk in a worst case scenario of the market dipping 50% in a week?
Thanks!
I try to beat the S&P in risk-adjusted terms. In retirement, I will scale down the risk to roughly target equity expected returns but at much lower risk.
I currently calibrate the strategy so that I gamble 10% of my principal. I am comfortable going up to 15% value at risk for a multi-decade worst case scenario.
I also write the contracts three times a week. The market will not drop by 50% between Monday and Wednesday. Well, if it does, we’ll have bigger problems than the stock market! I’d be shooting Zombies in that case and not worrying about the S&P500. 🙂
Also notice that there are “volatility clusters” i.e., a big drop usually doesn’t come out of nowhere. Normally the VIX is already high leading to the big event (think Lehman Brothers). When a big drop happens, chances are you sold puts way out of the money (premiums are really rich when the VIX is high) to give you an extra cushion against losses.
But for full disclosure: big events have happened (August 2011, August 2015, January 2016) and I suffered losses. But I still managed to keep the returns at 13-17% every year. This year could be the first time I reach 20% barring any bad blowup in Q4.
How do you manage the risk of a 1987-like-event with your trade? At 3x leverage, even if the puts were 5% out of the money, wouldn’t you still lose half of your investment in a day ((22% drop – 5% out of the money )* leverage ratio of 3 = 51% drop)? Is that just a risk that you’re willing to take given that leveraged put selling is so darned profitable?
Three ways to deal with that:
1: I believe we have better circuit breaker today than in 1987
2: Right now my income is still high and I can just replenish the portfolio and work a year longer. In retirement, I will likely run this at 2x leverage only.
3: I don’t have options data going that far back. But I suspect that implied vol was already extremely elevated the Friday before that Black Monday. I would suspect I would have sold about 8% out of the money. So “only” 12.47% times 2x leverage. 25% loss when the market lost 20.47%. Still bad but not the end of my retirement.
Great question! Thanks!
1. Circuit breakers won’t protect against a 20% drop in a day or 40% in 2 days.
2. If you are a year out from retirement, losing 50% of your investments would mean working a few more years and not just one more.
3. Vix has been reconstructed going back to black Monday and it jumped from 20 to 170 in a day. So there may not have been enough indication.
Maximum drawdown in your strategy can indeed be 50% or more. You just haven’t encountered an event like 2008 or 1987 yet. It feels like what Taleeb would call picking up pennies from in front of an incoming tank!
I’m not losing 50% of my investments. I’d lose 10% of my investment because I currently have only about 20% of my portfolio in this strategy.
I doubt that the VIX was 20 on the Friday before Black Monday. The index dropped by 5% on Friday, so whatever they “reconstructed” I wouldn’t trust their numbers.
I simulated an event like 2008-2009 and the strategy would have worked pretty well. The VIX went up in a pretty orderly fashion. 2008 the drawdown would have been a lot more moderate and shorter than with the S&P500.
Also remember: in retirement I will run this at 2x leverage. And any losses will be pre-tax.
But if you don’t like this strategy then don’t do it. It’s risky. I don’t judge anyone for not doing this
Historical VXO data is available for October 1987. While it’s not the same as VIX, it may be a prediction of what the VIX would do today leading up to a Black Monday.
VXO closing prices for the the 5 days leading up to Black Monday:
Monday: 24.59
Tuesday: 24.32
Wednesday: 26.36
Thursday: 27.86
Friday: 36.37
Black Monday: 150.19
Source for the prices above: http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index/vix-historical-data
Thanks!!!
Thanks!
At a “VIX” of 36 on Friday I would have sold puts at a minimum of 10% out of the money. So, a 21% drop on Monday would have caused a 33% loss with the 3x option position. Pretty bad, but not fatal.
Cheers!
You know big ERN, I’ve been trading options for over 15 years and you are one of the few who “get it”, especially in the FIRE community. It’s a shame more don’t explore this avenue, but I understand why they don’t. Thanks for spreading the word about options. Good luck on your trades and I hope you finally hit that 20% year! Of course on a ‘risk adjusted’ basis 🙂 I love the thinking there!
Thanks, Travis! Yup, close to 20% return this year. With an annualized standard deviation of under 2%, I might even get a Sharpe Ratio >10 for the first time ever. Options Trading is the way to go for income in retirement! 🙂
“Options Trading is the way to go for income in retirement!” Yup, I 1,000% agree.
Hi interesting post, thank you for sharing! I sell SPY options currently, when my account is bigger I want to move up to ES for the tax benefit. A couple questions if you have the time 1) do you let these go to expiration, or do you close for a set profit %? 2) it looks like liquidity can be bad in the futures options (low volume / wide bid ask) – I guess you accept the price you can get to fill immediately? Thanks in advance.
Thanks for stopping by! I sell put options on ES and let them expire. Even if they move so much out of the money that they are only worth $0.05. I don’t want to pay the transaction costs. 🙂
I never experienced illiquidity with the ES options during normal trading hours. Normally, the bid-ask spread is $0.10 to $0.15. I just place my limit order in the middle and often it’s executed right away.
Cheers!
Hi,
Just listened to your sequence of return risk podcast on Choose FI. I came over to check out your blog as I also trade futures and options. I’ve also been short vol most of the year, one thing that worries me though is that vol has been in such a downtrend, and the trade seems so one sided that eventually it stops working. In the last 10 years we’ve had 3 days with a 7% or more daily move in the S&P, flash crash 10% in 30 minutes, 2011 7%, 2015 7%, and overnight in the futures on election day was a 10% move. In a case of 1987 it was a 22% move in a day. For this reason I’m moving to hedge out this catastrophic scenario. Just curious have you modeled what a 10% daily move in the S&P would do to your portfolio? It seems so many people are short vol, not to mention the short vol ETF’s that if/when we do get a big spike in vol you’re gonna have a lot of money shorting S&P futures to hedge their vol book. I don’t think it’s unreasonable to consider there could be a positive feedback loop that could blow up some funds. What blew up Long Term Capital were events that hadn’t happened before, a 10% daily S&P move has happened, although infrequent, rather regularly. Just my thoughts, interested in yours.
Great points! I share some of the same concerns. But notice that I survived August 2015 and Jan/Feb 2016 and even the Brexit in June 2016 with 3x leverage. The calendar year return for 2015 was still 16% despite the Chinese devaluation. 2016 I made “only” 13%, but that was because the bond portion of the portfolio blew up post-election. Has since recovered in 2017!
Ways to deal with extreme skewness risk:
1: Do the put writing with the shortest possible horizon, i.e., write 3 times a week with a M/W/F expiration. If the end of the month falls on a T or Th, you even get 4 expiration dates. That hedges against the Augst 2015 and Jan 2016 scenario where the index fell by multiple % day after day for a week. Selling puts after a 5% drop you get much better premiums for the next expiration when implied vol is high!
2: Once I’m in retirement I will tread a little more cautiously, with “only” 2x leverage.
3: I might also consider doing a Bull Put Spread, i.e. sell a put x points out of the money and buy a protective put x+y points out of the money. And y is 5-10% of the underlying to limit the loss.
Cheers!
I really enjoyed this post, but I have concerns about the 3x downside leverage with something like Black Monday or similar happening again (e.g. – a large, sudden and persistent drop over a few days to weeks). For example, if war with N. Korea or something with Iran breaks out again unexpectedly.
Somewhere I saw you allude to something that might protect again such an apocalyptic scenario for those that are worried about it: buying (3x) puts that are even further out of the money? That way you accept the downside risk for the premiums you are getting but you can cap your risk so that it can’t wipe you out. Does that make sense? I’m pretty new at this options stuff, just trying to wrap my head around it right now.
Is that something you think might be worth it? Or would it eat too much into your premium gains to protect against a very low probability scenario? Is buying far out of the money puts really inexpensive / good value? Is there enough liquidity there that you get an efficient price?
Another thing that concerns me is that you seem to be varying your strike price based on the volatility in the market (i.e. – if things are volatile you sell puts ever further out of the money to reduce your risk). My concern is that I don’t have the knowledge to decide how far out I should go based on the current volatility and whether or not I’m being efficient. What kind of calculations are you doing to determine this or are you just kind of rule of thumbing it (e.g. – if VIX doubles, then I should double how far out of the money I go, etc.).
Any comments or ideas would be well appreciated!
Thanks!
Oh, another thing: how often does someone exercise their put options against you? And what is your process for realizing that has happened and responding? Do you turn around and sell the assets ASAP to get back to cash? How does that work with 3x leverage when you say most of your money is tied up in muni bonds? Do you have enough margin to allow it? Or does your broker just immediately sell for you (implicit margin call) or what? Are there any fees or penalties involved with that?
Just curious how this actually works in practice.
Thanks!
It happens around 4-5% of the time. Last year was such an amazing year, it happened only 1.7% of the time. But that’s an exception!
Put options on ES futures are exercised only at the expiration. I then end up with the ES future in the portfolio, which I turn around and sell immediately. If I see that the ES will end below the strike price I may even sell the ES future a few minutes before the expiration in which case the automatic execution will set the ES position back to zero.
Hi,
Im new to this but i read ES are american options, March, June, Sep, Dec . The other weeklyminis futures are european options exercised at expiration.
Is there a reason why u trade european ones and not the american ones?
Also i thought all the above are cash settled? Why do you end up with the ES future underlying?
You can read the contract specs here: http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500_contract_specifications.html
The futures contract is financially settled. The options on the futures contract are american style and settled in contracts of the underlying future. But given the liquidity of the options and underlying and the lack of a dividend, I wouldn’t expect early exercise.
Oops, I didn’t read all the specs myself. Looks like the weeklies are European style as you say, but that doesn’t change anything else I said.
Also, I believe the rational for trading the weeklies is purely due to the shorter time to expiration, not any consideration for the expiration style. If you plot out the potential premium to be sold in a year comparing different times to expiration, selling shorter term options provides you with exponentially more premium to sell than longer term options assuming you’re selling the same delta option.
I write the weekly options because the premiums are a little bit more generous. Plot the annualized option yield by the delta as a function of the delta and the closer to get to expiration the higher the curve shifts.
All options I trade are either cash-settled if they expire on the 3rd Friday of Mar/Jun/Sep/Dec because then the Future expires at the same time or physically settled on the other expiration dates, i.e., you end up with the ES future if the option is exercised.
Buying a put further out of the money is a good way to deal with the extreme tail risk. I know people who do that. You lose a bit on income it’s definitely a good hedge.
Knowing what’s the strike price is not rocket science. I just see what’s an acceptable premium that’s worth my time and money. Say, $3 for a week or $1 for an intra-week (e.g. Monday to Wednesday).
Depending on the VIX regime the “right” priced option will be far out of the money if the VIC is high and closer to at-the-money if the VIX is low.
Why not just buy in PUTW?
“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 [PUTW]. 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.”
Also, PUTW has a net expense ratio of 0.38%.
Yup. I can replicate that for a “fee” of 0.
Fees are too expensive. I prefer weekly options over monthly. I get higher returns.
Also, why work an hour 3x a week for expected annual returns of 6-8%? Plus risk. 15% makes sense, even 12%.
“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.”
Sorry, meant 8.5.
“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.”
Do you expect it’ll consistently return over the SPY average? Also, SPY was >20% this year. XUS >25. How is this comparing long term?
In blockbuster years the put writing will match or slightly underperform the SPX. But 2015 when the SPX was flat I made 15-16%.
Where else can you get a sustained (!) 8.5% after-tax (!) return with 6-8% (!) risk?
I think i’m not getting what you mean by risk. So do you mean downside?
I compare it to SPY ~7%. Perhaps I’m just not grasping something relativly complex.
Risk = annualized standard deviation of monthly returns. In Excel: stdev( … )*sqrt(12).
Equities have around 15% annualized risk over the long-haul (though much lower over the last 18 months!!!)
Gotcha. Ok very cool!
I had spent a lot of time trying to make a similar strategy work for me, but I kept running into the problem that the rare times you lose big it wipes out most/all of your gains to the point that being 100% VTSAX would’ve been better. I hadn’t thought of the muni bonds which is definitely an improvement on what I had come up with before discarding the strategy. I also was using stock options instead of ES options, but that difference doesn’t seem to significantly impact the returns. I was really hoping that you had found the pieces that had prevented me from getting this to work.
I think one thing that is still preventing me is this definition of risk. It seems to me that selling put options is far riskier than owning 100% stocks in the sense of what can happen if things go wrong. For example I can sell 10 puts on SPY with a strike of 278 right now SPY is at 280. I will make $860 if SPY stays over 278 for the 6 days, but if the market goes down 10%, I will lose over $25,000. If the market goes down the 22% it did during black Monday, I lose almost $60,000. I know this doesn’t occur often, but it does happen. I don’t think saying a 6-8% risk is descriptive of the real risk to your portfolio.
Am I missing something that you are doing that accounts for this?
$860 * 52 weeks = $44,720. Obviously, you wouldn’t win every week but the idea is that usually you win more than just holding the stocks to buffer against any sudden losses.
You could not leverage up.
You could sell even shorter term (M-T-F) options.
You can initially sell further out of the money to get more of a loss buffer before you start suffering losses.
You can also buy an offsetting option further out of the money to limit your downside risk.
All excellent points! Especially once you compute how much money the “pennies in front of the steamroller” amount to over an entire year this strategy looks pretty good! I have averaged over 60% profit margin on my puts over the last 7 years. So, for every $1 of option premium I generate I paid out only $0.40 due to the options getting into the money.
I personally budget 45% profit margin going forward and that still looks very good.
The disadvantage of the put selling strategy is that the upside is limited. But over longer horizons, the strategy is still about in line with the underlying, but with less risk:
https://www.cboe.com/framed/PDFframed.aspx?content=/micro/buywrite/put-oleg.pdf§ion=SECT_MINI_SITE&title=An%20Analysis%20of%20Index%20Option%20Writing%20with%20Monthly%20and%20Weekly%20Rollover
I have a similar question to Zachary’s above. Please excuse my ignorance in advance, too. I’m still learning the ropes here thanks to your great series.
With ES trading at 2797, I priced a put option on ES yesterday, 1/18, for a strike price of 2695 on 1/24. The bid was $1.60, so my premium would net me $1.50 x 50 = $80 (less fees).
But my potential downside is that ES declines past the strike price and my option gets exercised, meaning that I would need to buy 50 shares of ES at let’s say 2690 per share (slightly less than the strike price above as an example) = $134,500 – $80 premium = $134,420 that I must cover.
That seems like a remarkable amount of risk for ~ $80.
If I am reading the article correctly, though, you seem to indicate that you would buy the put option before expiration in order to limit losses. So in this example, let’s say just before expiration the same put option is now $30. So you buy this put option for $30 x 50 = $1500 – $80 premium = $1420 loss.
Is that sequence accurate? If so, how do you guard against the option’s being called before expiration, which I take to mean that you would then not have the opportunity to buy the offsetting put? American options can be called at any time prior to expiration, correct? Thus, what if someone calls your option a day before expiration, forcing you to buy the shares at the strike price?
I appreciate any guidance you give and thanks again for a great series and site overall.
Sorry, I mistyped my first equation. The bid was $1.60, so $1.60 x 50 = $80.
noted
Your risk would only be $134,750 if ES went to 0 which is inconceivable to me. You would buy $134,750 of the underlying but then immediately sell it for $134,250 for a loss of $500. I’m not as familiar with futures, but I think they might just look at the difference and take out the $500 which is a more efficient way of doing it. So no you don’t need to worry about losing $134,750, but your risk is significantly higher than your potential gains. Even your benign scenario of a 3.6% drop in price loses over 6 times your maximum gain.
At anytime you can buy the opposite option to cancel out your trade. You could also sell an option and then buy a further out the money option to create a “spread trade”. This allows you to set a maximum loss of the difference in strike prices minus the premium. My problem with these is that it significantly drops your upside.
I have heard this strategy of selling puts being described as picking up pennies off of train tracks with a train quickly approaching. You get lots of small gains until the train runs you over and wipes you out.
“I have heard this strategy of selling puts being described as picking up pennies off of train tracks with a train quickly approaching. You get lots of small gains until the train runs you over and wipes you out.”
That’s only true if you do this with large amounts of leverage. If you do this trade with only 1x “leverage,” then you actually have less downside risk than just holding the stocks (or futures) themselves. On the upside, you do have the risk of missing out on outsized gains. But, if you play it right (e.g. – only selling very short term options), then it is unlikely you will miss out on upside gains by much and you have less downside risk.
That is true. Then when I backtest using only 1x leverage, I end up with lower returns than just buying the underlying with much more work making trades, incurring transaction costs and creating taxable events.
I wish I could figure out how to backtest well. I haven’t gone that far down the rabbit hole yet.
I agree that implementing this strategy is a lot more work than just buying and holding something (e.g. – SPY, quarterly ES + bonds).
The tax on Section 1256 contracts simply means that you lever up the whole thing by 1/(1-tax).
T-costs are pretty minimal. And they are fully tax deductible!
Thank you very much for the detailed reply. The automatic buy-sell you describe makes sense given the high leverage of some traders, I suppose. I did examine the spread trade you mentioned and came to the same conclusion. I essentially cut my upside in half for the contracts I examined. I think I will try some contracts far out of the money to get my sea legs before I start with any leverage. Thanks again.
Good point. The art is to not take so much risk that you get wiped out. Remember, a naked put is actually less risky than a simple long equity position:
https://earlyretirementnowdotcom.files.wordpress.com/2018/01/putwriting-payoff-diagram21.png
When selling options you generally do need enough cash + lending margin in your account to buy and hold the underlying asset, in case the options get exercised against you.
However, in the case of E-mini S&P500s (/ES), the underlying instrument is a futures contract, which is really just a bet on whether the S&P500 index will go up or down. Because you aren’t buying the actual underlying stocks, but rather just a bet on which way they will collectively move, therefore the margin requirements to hold the futures bet are much, much, much lower than purchasing normal stocks.
Really, the only thing the market maker and your broker want to ensure is that you have enough cash + lending margin in your account to cover the potential losses on your bet. Typical initial margin requirements (i.e. – the cash + lending margin you need to buy a S&P500 futures contract) are something like 5% – 10% (they can be adjusted as market volatility changes) and the ongoing requirement (i.e. – the amount you need in your account so that your broker doesn’t liquidate for you) is lower.
For example, this morning /ES is trading at $2806. If I bought that contract, then it would be similar to holding 50 * $2806 = $140,300 of the underlying S&P 500 stocks. However, my broker (TD) will only reduce my account’s buying power by $5,280, meaning that their initial margin requirement is only $5,280 / $140,300 ~= 3.75%.
Because the margin requirement is so low (currently less than 1/20th), then I can easily leverage up if I want. Say, I only have $150K in my account. If I really felt confident that the S&P500 was going to go up, then I could easily buy 3, 5 or even 10 /ES contracts. Then my gains or losses would be magnified by that much too. Even at 10 contracts, my broker would only require that I have $52,800 in the account. Now, if the S&P500 dropped by 5% today, then that would translate to my account being debited $70,150 at the end of the day today, nearly cutting it in half. But my broker would still let my bet ride until my account got drained down to about $52,612 (ignoring lending margin). If my account dropped below that, then they would do a margin call on me and either I would have to sell some of the contracts or they would force me to do so.
Because margin requirements on futures are so small is exactly what enables the OP to use most of his money to buy muni bonds. Also, your broker will often consider such holdings as “equity” in your portfolio that can be liquidated to cover futures losses as needed. Therefore, the OP is able to act as if most of his money is dedicated towards the S&P500 while simultaneously holding a large bond position too.
Thank you for that example; that really helps me to see the margin requirements more fully. I suppose part of the issue is that my broker, Schwab, does not transparently display the margin requirements for a given trade. I had to chat with a rep this afternoon to determine the requirement. (They claim a calculator is forthcoming.)
One question, though: You stated that if the S&P dropped by 5%, then your account would be debited for $70,150. I understand that number is 10x (5% x $140,300). But why would your account be debited? I thought nothing happened in your account until the contract expired (or someone called your option).
Your account is not debited or credited for your options positions until expiration or exercise. But if you hold an ES futures contract (not an option), your account will be debited (cash settled) every day.
Options on futures are marked to market every day! So, every day you’ll see a P&L from the short options! Even before the expiration!
Your account is debited and credited every day. It’s called mark to market.
Yup! That’s what I do! 🙂
Good point! I normally keep many times the required minimum margin in my account. Short puts require about $10k per contract, but I keep about 40-45k in margin. You can use mutual funds and ETFs as marginable assets. Works pretty well with Muni bond funds!
The P&L calculation works differently: If the ES future falls below the 2695 strike you only owe the amount below 2695 multiplied by 50. So if ES falls to 2680 your loss is 50times(2695-2680)=$750. A substantial loss, but keep in mind that with the current low volatility it’s highly unlikely the index will fall that much in such a short time frame.
Also, the futures options don’t get called before the expiration date. They get exercised automatically at the expiration date/time.
Very helpful information. Thank you. I think much of my confusion/concern stemmed from my uncertainty about the futures options being called prior to expiration.
There are some American style options, but the ones I trade are all European Style:
http://www.cmegroup.com/trading/equity-index/us-index/e-mini-sandp500_contractSpecs_options.html?optionProductId=138#optionProductId=2915
Check out:
Weekly Options
Weekly Monday Options
Weekly Wednesday Options
End of the Month Options
They are all Euro Style and they say:
“European Style. Exercisable only on expiration day.
Option exercise results in a position in the underlying cash-settled futures contract. Options which are in-the-money on the last day of trading are automatically exercised. A 4:00 p.m. ET price fixing based on the weighted average traded price fixing (symbol ESF) of the E-mini S&P 500 futures in the last 30 seconds of trading on expiration day (3:59:30 p.m.-4:00:00 p.m. ET) will be used to determine which options are in-the-money. Contrarian instructions are prohibited.”
That should ready “your account will be debited or credited (cash settled) every day”, based on the market movement for that day.
Thank you for the reply. So if I sell a put option on the S&P mini, then I would only be debited (if necessary) at expiration/exercise, correct? Otherwise, I simply keep the premium if the strike price is not reached.
That has been my experience for the 6 months that I’ve been selling puts on ES. I have not had a put exercised yet (2017 never saw a decline deep enough).
One thing to note: while your put contract is active (not yet expired), your margin requirement will go up and down as the index price, volatility, and time to expiration change. If you ever get into a situation where your margin requirement exceeds your available funds, your broker can close the put option by buying the contract at whatever the going rate is, which may be higher than you sold it for, resulting in a loss. In other words, you can still lose money even if you sell an out-of-the-money put, and it never goes in the money.
The last 6months were pretty extraordinary. It may not stay that way.
But note that the short puts are marked to market every day. If I sell a contract at $1.00 in the morning ($50 premium) and ES drops and the put value goes to $4.00 by the end of the day, then I will see the loss of $150 (=50 times 3) at the end of the day. Now, the put may eventually still expire worthless after 2 more days and I will make the money back, but in the interim, I could face sizable losses! Happened to me many times! 🙂
So that interim loss of $150 you mention is the mark to market, correct? That amount would then be debited from your account that day, but if the strike price is not ultimately reached in two days, you will make that money back. Do I have that sequence correct?
Correct! If you’re lucky and the strike price is not reached at the expiration time you will make that loss back! 🙂
Very helpful. Thanks for your explanation.
What happened today? Would be interesting to hear if anyone was hit by the train….. I was, I closed it out rather then have it automatically exercise, although I think it is better to let it automatically expire. I actually use SPX (thats the symbol on etrade)
Less than a 2-sigma event for me. Obviously a loss, but something I plan for to occur several times a year.
But it shows the benefit of writing the options super-short-term. Today’s strikes were 2770-2775, and ended up on average 11.80 in the money. About 4 weeks of revenue went poof.
The strike prices I sold last Friday were above 2800. If I had written them for a week I would have lost a lot more! 🙂
Do you close the contracts or just let them be automatically exercised and cash settled? Closing would imply some sort of timing or picking when is a good time to close. Letting them get automatically exercised would seem to be less timing of the market. And I guess the point is to continue writing, especially now as premiums are higher and are needed to make up for the losses?
My Futures options are settled physically, except for the rare occasion when Future and the option on future expire on the same date/time (4x a year on the 3rd Friday of the month). If 1 minute before expiration I see that I will be exercised I would short the future (and I’d lock in the loss). Then upon expiration, I get the future back and have zero position in both the future and put after expiration:
3:58:00PM: Put position: -1
3:59:00PM: Put position: -1, Future position -1
4:00:00PM: Put position: 0, Future position: 0
But I’ve also had cases where the future bounced around my strike and I had to wait until the last second (literally) to make sure the put expires worthless. More excitement than the last 60 seconds of a basketball game!!! 🙂
I took my short vol positions off a couple weeks ago when I noticed vol and the S&P both rallying, and rates rising. I also put on my portfolio hedges.
I believe anyone selling vol should go and listen to the January 25th episode of MacroVoices with Chris Cole. It’s the best bear case for selling vol I’ve heard. Whether you agree or not it’s always a good idea to hear the best opposing view you can find, and that’s it. I’d be interesting to hear everyone’s view on it. Being short vol was one of my best trades last year, but with this move in rates I’m scaling back for now.
Interesting! But if you regularly sell vol, now at higher IV and higher premiums that shouldn’t be e problem. It should only be a problem for those who sold the monthly VIX futures at 11 and now lose money every day for a month.
How are you guys handling this VIX doubling?
Another tough day. If you roll your positions fast enough it’s much easier to handle. I sold some puts on S&P futures with a 2400 strike. Expiration Wednesday. They have an implied vol of >100%. That’s crazy even when the VIX index is “only” at 37%. I hope I can make some money back by Wednesday…
This is the problem I have with selling more vol in a spike, you’re essentially averaging down, which works great as the VIX generally mean reverts, but what happens when like today it just doubles again, then possibly again? If you get your sizing right you may be OK, but it’s just not a risk I can take. I’m not saying it doesn’t work for some, just like my strategies won’t work for a lot of people. I’m fascinated by the strategy though, and look forward to following it’s implementation. I know you’ve been though some volatile markets, hopefully this one doesn’t hurt to much.
Yes. That’s the problem with selling VIX futures. There is a VIX jump large enough that will wipe out the portfolio. I guess they were too greedy when they calibrated their ETN.
I remember when we were trading around 2,000 in SPX I was able to sell some 1600 puts for a ridiculous credit. Selling 2,400 with a Wed expiry for that vol seems like a decent RR for a short term trade. Did you see whats happening with XIV? Looks like the short VIX ETN’s are blowing up.
Saw it! Pretty scary!!! That’s why I prefer put selling, not VIX shorting:
https://earlyretirementnow.com/2017/10/25/returned-over-100-percent-year-to-date-still-not-buying-it/
Looks like that Wed 2400 expiry worked well. You still selling lower?
My strikes on Wednesday and Today were ok. Already made back a good chunk of Monday’s loss. Strikes for next Monday at 2500-2550!
No, you will face the mark to market (P&L) every day and you will face margin constraints that are calculated new every day!
Hi just wanted to say you are my favorite math based FI blog! You mentioned that you are reducing your leverage ratio on your options strategy from 3x to 2x, is this more from lowering of tax brackets or reducing risk? What ratio would you do if you were in the 24% bracket and in the accumulation phase?
Thanks! 24% federal bracket and what’s the state bracket? I would probably do 2.5x. But then that depends on how much risk are you taking on: If you’re writing at the money options with a 50-delta it has to be much less. I’m talking about 3x leverage with an initial 10-delta on he puts because they are significantly out of the money!
Do you typically target 10-15 delta puts as the strikes to sell (while using 3x leverage)? Thanks!
Currently, I write puts at around 7 delta (i.e., -0.07 delta) puts. With about 2.2x leverage.
How are you faring with this strategy given the recent volatility? When these puts exploded to being ITM, do you hold on to the futures? I’m down about 7% on my portfolio due to these writes :(.
The strategy did OK. Lost some on Feb 5 but I made all the options premiums since then.
I never hold on to the futures when the options go ITM. I simply sell the futures and roll into another out of the money Put.
ERN, this strategy has been generating quite a bit of news in the past 2 weeks…..
https://www.zerohedge.com/news/2018-02-15/2016-pension-funds-started-selling-market-puts-then-last-week-everything-went-wrong
XIV got absolutely crushed, but that isn’t what ERN is doing. In fact, ERN has an old blog post about how XIV is far too risky even though it was returning outsized returns over the last 2 years. It is true that a volatility strike from out of the blue will hurt this strategy, but then a spike in volatility usually means volatility stays high for a good while, meaning higher premiums. Let the smoke clear and see how this strategy plays out over this entire 1 – 2 quarters. Then we can all better judge.
The article talks specifically about “selling market puts”. But I think generally the question is has this been working because of low volatility, I understand ERN back tested this over times of high vol and the premiums are higher during these times, but for individuals to use this strategy low volatility means the blow ups are relatively not that bad, but if we return to a higher level of volatility or days like Feb 5 it takes a lot more discipline to continue the strategy, ironically maybe the fees of WPUT are worth it for the discipline it brings.
The article is kind of on topic, but mostly off.
They do have a great point about XIV getting crushed out of the blue. ERN explicitly warned about that risk specifically with XIV in the past back when it was still skyrocketing higher. Other than that, the article is mostly just wrong. It even bolds this commentary as if it is somehow making Zerohedge’s point:
“”So far this month, the fund has lost 4.37%, through Feb 12, though that tops a loss of 4.52% for its benchmark, a mix of puts on stock indexes and compares with a 5.90% loss for the S&P 500 through that date.”
Neuberger’s not worried though. “The efficacy of these strategies manifests itself over months and quarters,” said Doug Kramer, who oversees the PutWrite strategy. “Everything’s functioning as designed. We’re happy to have higher volatility and be able to underwrite higher option premiums.””
So, one of the put-writing funds suffered an initial loss due to the volatility spike, but lost less than the S&P500 did in the same time period. And this somehow demonstrates Zerohedge’s thesis? I don’t think so.
“But I think generally the question is has this been working because of low volatility”
If anything, I think low volatility makes this strategy riskier. Premiums go down and a large %-wise spike up becomes more likely. If you already have high volatility, then premiums are (much) higher and it is much less likely that vol can spike up hugely %-wise.
Yup, it takes some discipline to keep doing this after a big drop! I have done it many times before (2011, 2015, 2016 and now in February).
Exactly! Normally, the Put selling strategy recovers after a few months. Even from a pretty bad event like August 2015, January 2016 or February 2018.
Thanks for the link! I can’t speak for the Neuberger Berman product, but I have run my put selling strategy successfully for years. It definitely beats VIX futures selling.
Do you delineate between an option yield and your expected RoR annualized? I see a lot of calculations that compute option writing returns using the initial or the maintenance margin required to carry the position.
You don’t seem to pay attention to that when determining yield, is there a reason?
Expected annual return = OptionYield x Leverage x (1-LossProvision) x (1- TaxRate).
I would never calculate the option premium yield as a % of the margin. It’s always as a % of the notional underlying. Margin requirements can change and I would never shift the leverage up so high that I get even close to the margin constraint.
What are the mechanics if your position works against, so you have to login to sell your bonds that your are holding against or do they do that automatically?
So far, knock on wood, the drawdowns have been mild enough that I never had to sell the muni bond funds. The exchange will only automatically clean out your futures positions if you don’t satisfy a margin call.
The reason this works fairly well is that you write more out of the money options when volatility is higher by seeking a constant premium yield. That is a very clever feature. Also, being able to continuously write options with expiration only a day or two ahead is a very nice feature. I might actually try this, though I would try to improve it using a model 🙂
Thanks! Let me know if you come up with a better model! 🙂
Have you ever watched Tastytrade? They talk about this stuff all day long. They would say you’re taking more gamma risk than necessary by selling such short term options, but it sounds like you’ve been doing well. They advocate (based on back testing) selling 14-30 delta options around 45 days to expiration and closing them when they reach ~50% of max profit or at about 21 days until expiration. They also like to sell more options when the volatility is high relative to it’s historical average. Their rule of thumb is that over time you can expect to keep about 25% of the option premium you sell.
I’ve been trying a delta neutral strategy for the last few years – selling puts and calls at equal deltas. Last year was pretty rough for that given the constant grind upwards, and I also kept my leverage small given the declining Vix. 2016 was decent though.
Yeah, these guys are some characters! A little bit too full of themselves to watch this regularly! 🙂
My target is to keep 45% of the option premium I collect. Historically, the average was 55%, but I budget conservatively for the future.
Selling puts and calls with equal delta must have been tough with the wild swings recently! I thought about that and also short puts plus delta hedging, but in the end I always converge back to my good old tested strategy. 🙂
The big problem for me this year was in February when the market dropped and volatility went way up. Both sides of my positions were losing from that. That seems to illustrate some of the differences between your strategy and mine. Due to your short time to expiration, your types of positions have about 1/4 the vega that mine do, but about 4x the gamma.
I have been trying delta hedging this year, adjusting with ES futures against the beta weighted delta of my whole portfolio. I found last year via backtesting my own trading data that if I had hedged my portfolio to neutral once a week I would have made significantly more money. However this year with the higher realized volatility, that hasn’t worked. I’ve been whipsawed twice. I’ve decided maybe that method (called reverse gamma scalping, I believe) seems to work in a trending, one direction market like we had last year but not in a market like this year with all the reversals. Of course if I knew the market was going to trend in a direction, there would be more efficient ways to make money…
Firstly, what a great website with so much good information. Thank you.
On you option trading strategy, I have question. Why not write options on MINI SPX (.XSP) ?
They are also cash settled and are covered under 1256 of the Tax Code. Their margins requirements are also decent (~ 25%).
Do you see any other advantage of writing options on S&P future (as you do) as opposed to on .XSP ?
Haven’t checked that out (yet). The reason is that I would need trading clearance from my workplace for all options trades, except futures options. So, currently I trade the instrument with less of a hassle. But in retirement I might consider XSP as well!
Hi ERN,
Thanks for sharing. I read that you sell out of the money ES future puts with strikes that are close to the money and have about 3 days to expiry.
So i have been thinking which is riskier…
A 3 months to expiry put and a further out of the money strike
OR
A 3 day to expiry put and a nearer out of the money strike?
Personally, for the same annualised return, for a 3 months to expiry put, i can buffer for the index to fall up to 25% before hitting the strike, but for a 3 days to expiry put, i can only buffer up to 3% before hitting the strike. ( this % is not backtested vigorously, just a data point)
So which is riskier?
For me, i would rather the 3 months to expiry one because it SEEMS 25% is a lot of buffer, compared with 3%
I hope no one minds me replying here. If you sell the same delta for each expiration, in theory you have about the same probability of each option being out of the money at expiration based on the current implied volatility. Said another way, for a given implied volatility (think of it as a standard deviation), the further you go out in time, the larger the possible move in price. Thus the reason that you can sell an option further out of the money for the same price further out in time. Of course as soon as the market moves after you’ve sold the option, all that can go out the window. However in my personal experience selling options in the ~45 day time to expiration range, those probabilities do hold up. If you close profitable positions early (before expiration when they’ve reached some profit target, for example 50% of what you sold the option for), then you can improve your win rate even more. Whether or not you make money then depends on how big your (somewhat rare) losses are compared with your frequent (but small) gains. Also, if you are directionally right over the long term it helps – for example you sell puts in a bull market.
If for some reason you think the market will move down to some resistance level and not go below, I can see where you might find selling longer term options at that level appealing. However be aware that if the market makes a 25% move down towards that point, you will still likely experience losses between when you sell the put and expiration due to the likely expansion in implied volatility associated with such a move as well as the price component of the directional move. Longer term options are more sensitive to changes in volatility than short term options. You can get an idea of what your losses on such a move would be in the near term by looking at the price of the current at the money put versus the put you’re thinking about selling and then multiplying that premium by several times for an increase in volatility.
Not quite sure I follow your logic here. For a 25% OOM put you get essentially nothing. Example: ES trading at around 2710 today.
For a put with a strike of 0.75×2710 = about 2025, the July put costs about $4.00. About $0.04 premium per day.
For the April 20 put, 3% out of the money is 2625 you make $1.30. That’s $0.43 per day, ten times the premium of the July option.
So, just like you I would also very much prefer 25% buffer over 3 months. But your return is also cut by 90%.