Passive income through option writing: Part 2

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.

put-option-quotes-9-28-2016
Market Snapshot: 9/28/2016 around noon Eastern time

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:

  1. 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).
  2. 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):

puty-option-case-study3
Despite 3x leverage, we experienced less volatility than the index and we made more money than the index that week. Sweet!
  • 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!)

puty-option-case-study1
Case Study: when put writing with 3x leverage can go horribly wrong!

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.

puty-option-case-study2
Case Study: option writing worked beautifully during the Brexit week

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.

put-option-3xlev-actual-returns-2014-16
Cumulative Return Comparison (chart at weekly frequency, return stats based on monthly returns)

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.

Thanks for stopping by. We hope you enjoyed our post. Please leave comments, questions, complaints (really!?), etc. in the comments section below! We’ll be traveling this week, so we might be slow responding, though!

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200 thoughts on “Passive income through option writing: Part 2

  1. Thanks John.
    Can you share whats your cut loss strategy is?

    I am trying out the “cut loss when i lose the whole premium” i sold for that expiry, but i would think if i do a very short to expiry like what ERN does, i would be cutting loss ever so often as the premium is little, and as you mentioned, an increase in implied volitlity , even if the price is stagnant would make me cut loss.

    Im still trying to find my comfort zone between ERN ways ( weekly or lesser expiry) and optionsellers.com ways ( 6 months away with futher OTM)

    Liked by 1 person

    • I don’t really have a strategy around losses other than keeping track of my leverage (keeping it where I want it, not letting it get too high) and increasing leverage when volatility is higher / decreasing when vol is lower. I’ve seen studies from Tastytrade around closing a loss around 2x the credit received, but they aren’t super compelling and they say they don’t usually do that in their own trading. I think they’ve also looked at closing positions when the option goes in the money. I think 1x the credit would be too tight of a limit. A lot of times the position will come back as you allow time to pass, and if you get out at the lowest point you’re giving up the opportunity for that to occur. In the past I have extended that idea in time by ‘rolling’ positions forward. That means if I have a losing option, I’ll close it and sell an option in the next expiration cycle at the same strike for more money or possibly for the same money at a lower strike. This has pros and cons – you now have a position with lower probability of success as the strike is closer to the underlying’s price / the delta is larger, but if the underlying goes sideways for long enough or if it reverses back up, you can make back some or all of what you lost. Alternatively, you can close the position and move to the next expiration and start again selling the same delta put you always do. Statistically this should produce more winners over time but it takes longer to dig out of the hole of a large loss. I am still digging out from the February drop after using this method where as if I’d rolled out in time for a small credit I’d probably be about back to even by now. But if the market had continued dropping, I would have been better off from doing what I did.

      Mostly I focus on closing winning positions a bit earlier to try to prevent them from turning into losses. For example, with the up move today I closed Wednesday /ES options I had sold when they reached around 0.40 of premium left ($20). I had made about 85% of the possible max profit and I didn’t think it was worth the risk of leaving them on all day today and tomorrow to pick up that last $20 and avoid the ~$3 charge to buy them back.

      Liked by 1 person

      • Thanks John for sharing. February drop was bad and unexpected.

        1X credit to cut loss really is too little, which would necessitate a longer expiry to allow such a cut loss strategy.
        Still feeling my way around and will be trying to regularly sell a monthly SPY put with 10.5% below strike with an annualised yield of about 15% on initial margin req. ( i actually will fund a 1.5 X initial margin marquirement for safety for a annualised yield of 10%). Not much but safety first.

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        • If I’m interpreting you correctly, you would sell the monthly May 240 put tomorrow for example which would have ~30 days to expiration, for ~0.30. If you use 3x notional leverage eventually, that would only be about a 4.5% annual return selling such a far out of the money put, and that’s assuming you keep the entire credit all the time. That’s fine for learning, but I would suggest you are taking risk without a lot of potential return and may want to go a bit closer to the money in the future. Also make sure your commissions aren’t going to eat up too much of your potential profit.

          Liked by 1 person

          • Hi John,

            3X leverage means, say, SPY is 270, strike is 248, initial margin is USD3231 and you have USD9693 (3X initial margin) as a back up? Do you mean this?

            For me, im doing, say, SPY 270, strike is 248, initial margin is USD3231 and i am having USD4846 ( 1.5 X initial margin) as a back up instead.

            So its a matter of playing around with the margin and the distance of the strike that would determine the annualized yield.

            Further OTM, less margin required but less premium
            Nearer OTM, more margin required but higher premium

            I am going for the “Further OTM, less margin required but less premium “

            Liked by 1 person

            • I look at leverage in relation to the amount of stock you could potentially be taking of delivery of if your put went in the money, not in relation to the margin. So say you sell the 248 SPY put. That means worst case you are buying (or have the same risk as buying) 100 shares at $248/share. So the ‘notional’ value is 248*100=$24800. So say you have a $100k account. If you sold 4x 248 puts, that would be ~1x notional leverage. 3x notional leverage would be 12x 248 puts. The range I have heard suggested and used myself is 2x-6x notional leverage for your entire account when you are selling options like this. 6x would be quite aggressive and I would only do that if implied volatility was very high and I thought it was a great opportunity or you have a very high risk tolerance. I was targeting more like 2x at the start of the year when volatility was at historic lows and currently a bit over 2x, similar to ERN.

              Then to calculate yield, look at how many puts you can sell for some level of leverage, the premium you might collect from that in a year, and then divide by your account value. Or ERN posted a more direct formula in a previous comment. Then realize that in reality you might not keep all that premium, so depending on what you’re doing and how much the market accommodates you, you might keep between 25% and 75% of the premium you sell over time. Margin only enters in for capital management reasons. Ie, you don’t want to be using all your margin so that you’re in danger of getting a margin call and being forced to liquidate your positions if you suffer some losses. I would expect to use between 20-40% of your available margin at the low end of leverage and maybe up to 60% at the high end, but the relationship between leverage and margin usage will depend on what type of account you have.

              Liked by 1 person

              • Thank you John. Your reply is very clear. Based on what you mention, i am doing a ~ 6X leverage.

                1 contract , SPY May18’18 241 put , premium $0.35, 6X leverage, ~10.2% pa, underlying 268.89

                So with a larger leverage, the strike can be further out.

                Im still 2 weeks old to options, so still wondering how a spike in volatility will hit my margin. Will wait for one before i add more funds .

                Thanks again, difficult to find a good forum without people saying rude remarks to one another

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            • I calculate leverage based on the notional. Example: ES future at 2650. Sell a put at 2575. Multiplier of 50. So one short put has potential maximum loss of 2575×50=$128,750. If I hold $60,000 in funds in the account then I have a little bit more than 2x leverage for one short put.

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  2. Hi Big Ern, great article! I just newly discovered FI a couple months ago, but have been actively manage my own money using options. I also just started dwelving more into the world of futures. Just wondering how did you manage your positions during the Feb 5th, 2018 drop? Looking forward to exchange some ideas.

    Liked by 1 person

      • ERN, please help me understand your long-term confidence in the Sell Put strategy. Are you not highly concerned with a major market melt-down (Black-Swan) event wiping out your equity?

        I am intrigued by your approach – but can’t ease my concern for the long-tail event. Any supporting comment will be appreciated.

        Liked by 1 person

        • The big left tail event would have to all happen in 1-2 days. Unlikely. Even during the GFC the decline of 57% was over 17 months.
          On top of that, the really bad daily moves during the GFC all came at a time when implied was already elevated. I simulated this strategy during 2008/9 and it worked pretty well.

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  3. You seem to refer to “bond funds” and “longer-duration bonds” sort of interchangeably here; am I correct to assume that you’re only holding bond funds (and if so, why those particular ones?) and not the bonds directly via IB?

    Liked by 1 person

    • I read ERN’s article as being pretty clear about a fund, but I am somewhat interested in this as well. I personally hold treasury bonds directly currently through TD with a large portion of the cash in my account. I have them in a ladder skewed towards the short end of the spectrum. I looked at the tax free muni’s, but their yield is really low on the shorter durations such that the after tax rate of the treasuries was about the same, but I would think the treasuries have less risk. I imagine sometimes it would be advantageous to hold the bonds directly and sometimes more so to hold the fund. For example, holding TLT with the same value as the bonds I hold would have lost me a significant amount of money over the last 3 days while the market also moved lower. However my bonds barely moved at all. But if bonds and the S&P had moved opposite each other as frequently happens holding TLT would have worked in my advantage. In all fairness I am holding shorter duration bonds than what TLT does. I just trade TLT frequently so it’s an easy comparison.

      Liked by 1 person

        • Really? Do you have to pay to buy a bond at IB? I don’t pay anything directly as a fee to buy bonds through TD. As far as I can tell they just mark up the price slightly and show you that in the form of a lower yield to maturity. You get a volume discount as well, so the more you buy the higher the yield. If I wanted to sell the bonds back they would ding me on the way out as well. However this seems to work out to about 0.04-0.05% only buying them (I just bought some this morning and that is where they’re marked at relative to what I bought them for). On BCHYX, the expenses are 0.5%, NAD is 0.95%, NAC is 0.98%, PFF is 0.47%, so it seems to be about 10-20x higher for the funds. If you were buying longer duration bonds (more than 1 year), comparatively the fees would be even lower on the individual bonds as the bond fund is going to be taking that out every year where as I should only be paying once when I buy something. I am buying in $50k-$100k lots typically.

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          • While I can’t speak to the costs of IB vs TD, another thing to consider in the context of this post is how holding bonds at TD differs from holding something with IB for margin-related purposes. I’m assuming this is a factor too, although it doesn’t specifically answer your questions if I’m reading this right.

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            • I’m not sure what the difference would be there… At TD the margin on treasury bonds is 5% of the face value, at least in my PM account. However it reduces your cash balance by the full value of the bond. You would be charged margin interest if you took your cash value below 0. This works quite nicely with the type of futures trading strategies ERN has talked about in several posts. I can have a 2-3x leveraged position in the ES futures and still hold a large percentage of the net liquidating value of my account in interest-bearing bonds while only using ~15-25% of my available margin.

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          • Once I stop working (without the compliance hassle from work) I will definitely check out holding individual bonds directly!
            How about bid-ask spreads? I am not interested in Treasuries, but exotic low-volume CA Muni bonds!

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            • There is no published bid-ask spread. That is effectively the markup (or lower yield to maturity) that you’re quoted. I think you’re just trading with the broker which in this case is functioning as a bond dealer. So they make you a market in whatever you are interested in of their inventory and you can either buy at the price offered or not. Also, it seems like someone is looking at each trade. I’m not sure if it’s manually done or is computerized, but the trades don’t execute instantly. To look at the spread, what I’ve done is looked at the yield on a 1 year bond that I can buy at TD and compared to the published rate on that day and noticed a slight difference (around what I quoted before) or looked at where they marked the bond after I bought it and it was marked slightly lower (that same 0.04-0.05%). Then if you sold it back to them, you’d get charged about the same again. So I think they’re marking in the middle of the effective bid-ask spread and you have to buy at the ask and sell at the bid.

              They do have corporate and muni bonds as well as the treasuries I’ve been trading. They only sell from AAA to A rated, so the yields might be lower than some of the stuff you’ve been looking at. BCHYX for example lists it’s average credit rating as BB so I’d expect a higher yield. They do have some CA muni bonds – just quickly looking I found, for example: SAN FRANCISCO CALIF CITY & CNTY ARPTS COMMN INTL ARPT REV REV REF BDS AIRPORTS REV ALL BONDS Ser 2011B, Non Callable, CUSIP: 79765A7U4. That has ~3 years to expiration, they have $450k of them and it yields 1.652% to maturity. They list the minimum buy at $50k, although sometimes what they list overnight is higher minimums than during the day – not sure why. Orders only execute during the normal trading day. If you go longer duration, yields go up to a max of 4.3% in the A-rated munis that they have at the moment.

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                • Are you talking about NAC? If I’m calculating this wrong please let me know (I’m just getting into bonds), but looking at the last year it looks like you would have lost about 4.8% after including the distributions and price change. Going back 3 years, it looks like you would have made 0.6% per year on average. So even though it has paid distributions at a rate of 4.7% over the last year given the year ago price, it seems like the total return in the recent past is worse than the ~1 year treasuries I’m buying at the moment even after considering the federal taxes on the treasury bonds. And you could get more yield in the treasuries by going longer term which is probably more comparable to the duration of NAC (but that is a guess – I can’t find an average duration).

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                • Going longer term in Treasury bonds exposes you to the same duration risk, i.e., you lose money when yields go up.
                  Also, keep in mind that I pay close to 50% in marginal taxes right now (federal+state+Obamacare). The 2.3% yield on the 1-year T-bill is then only 1.15% after tax for me.
                  If I get 5.3% yield on the Muni fund and I lose, say, 4.7% for a net gain of 0.6% I would still beat your T-bill. That’s because I regularly (quarterly) harvest losses from the Muni funds and the 4.7% loss generates a 2.35% offset to ordinary income (0.4 times my Section1256 gains plus $3000 of ordinary income each year with carry-over), so the 0.6% gain according to your calculation is actually a 0.%6+2.35%=2.95% after-tax return.
                  And at some point, the bond market might stabilize again and I get to keep a lot more of the 5.3%.
                  But your tax situation might be different. Either way, I wish you best of luck with your T-bills

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                • Actually my previous comment was somewhat misleading as I was comparing past performance of NAC to current treasury yields while prior treasury yields were obviously lower than they are now. To compare to NAC, if you had also bought a 3 year treasury bond 3 years ago (when rates were much lower), it would have returned something like 0.5-0.6% per year after taxes depending on your tax bracket, so about the same as NAC. If you had bought a 10 year treasury 3 years ago, you would now be down money on it – I think about 0.3% per year on average over 3 years (not taking into account what you would have paid in taxes on interest received). If you had bought a 10 year 1 year ago, I think you would currently be down about 3.3% on it (also not including taxes on the interest). And if you had bought 1 year bonds 3 years in a row, you’d be up ~0.7% total or ~0.2% per year on average including the effect of taxes.

                  Liked by 1 person

                • I’ll have to think about the tax loss harvesting. Haven’t done that before. However you don’t have a 50% marginal rate for treasuries – you don’t have to pay state taxes on them. I’m in the same marginal bracket as you.

                  Liked by 1 person

                • Ah, that’s right! “Only” 40% marginal rate for those! 🙂
                  But check it out: rotating between the CEFs and harvesting losses makes a lot of sense and can offset some of the short-term gains from the 1256 contracts!

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                • After doing the calculations for tax loss harvesting, I get your point that you have quite a large margin for taking losses on the muni fund before dropping down to the yield of the treasuries. For the NAC example going forward, it looks like you could lose about 7.5% of principal before dropping to the total portfolio return a 1 year treasury bond would currently provide (I’ve been doing short duration as that seems to be the more attractive area of the yield curve to me currently). A bond ladder of 1 year treasuries would have been better over the last year as rates started to rise, but only barely.

                  After reading some more about closed end funds and looking at the historical performance of NAC, the two things that still worry me are the bad performance in a rising rate environment (as we’ve been in for the recent past and quite possibly will be in for at least the near future) and how the fund performed in 2008. I see NAC lost about 40% of its value at one point in 2008 before bouncing back. It looks like about half of this was the discount to NAV increasing. This would seem to be a fairly undesirable characteristic in a position that is supposed to be offsetting an equity position which would have also been taking some substantial losses around that time. It is a bit tempting at the moment though given it’s towards the high end of its historical discount to NAV. It would be a big boost to overall portfolio returns if it bounced back in price.

                  Liked by 1 person

                • You got that right! Rising rates are poison! And illiquid investments got hammered during the GFC, but I’m not sure this will repeat in every garden-variety recession.
                  But if you have the guts to have this fund around the time the rate hikes level off you can make a lot of money! And it’s all on top of the options trading! 🙂

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  4. Hi! I just started reading your blog and love the detailed analyses! Two questions regarding the put option writing:

    1) From what I’ve researched, options on SPX (not the SPY options on the ETF) are settled in cash and Section 1256 applies to these as well. Is that correct? My broker does not allow me to write naked puts on futures, but I can write naked puts on SPX.

    2) How are you computing the risk per annum of 6.4% on all your trades?

    Thanks!

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    • 1: I’ve never traded the SPX options (not allowed right now due to compliance rules at work). But it sounds correct; they should be settled in cash. But double-check with your broker and the exchange.
      2: This is just the annualized realized standard deviation, i.e., monthly times sqrt(12).

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  5. Forgive my ignorance but given the use of leverage, I presume you close out your losses prior to assignment of the futures contract? I work in finance but newer to put writing so right now doing only cash covered puts w/o leverage.

    I guess the original thought I had was to write at a steeper 5%+ discount to weekly SPY/QQQ and be happy to get assigned those ETFs if the trade went the wrong way (since this is money that would have been allocated to equities anyway and historically 5%+ weekly down legs are more short lived outside of a recessionary turn). Had then thought to write covered calls on those long SPY/QQQ positions I was assigned.

    Your concept intrigued me though so I was just wondering 1) about how/when you decide to cut bait and (presumably) buy to close your position on the e-minis and 2) if anyone has explored put writing then covered call writing upon assignment–would imagine that is more conservative but again I’m newer to this and could absolutely be missing something critical.

    Any thoughts you guys have would be greatly appreciated!!

    Liked by 1 person

    • With the futures, the margin doesn’t change if you get assigned (at least at my broker) and your directional risk doesn’t change after assignment (you would have the same deltas). So the reason to close out your puts before assignment if they’re in the money or close the futures after assignment would be if you didn’t want to continue to have that level of directional risk. For example if you wanted to be long at that level of leverage at that price level, you could just leave the position on. However personally I would likely close the position and reestablish a new options position in the next expiration cycle with the same delta I always use in order to get back to a higher probability of success.

      With ETF options, if you get assigned it can become a cash management issue. The cash to buy the stock will be deducted from your account’s cash balance. If you’ve already used a large amount of your cash balance to buy bonds, this could cause you to incur margin interest charges. Some brokers also charge high assignment fees. For example, TD charges $20 for assignment per option strike on their basic rate plan which is pretty terrible. By the way, commissions are negotiable if you have enough money and do enough business with your broker.

      Covered calls are the synthetic equivalent of naked puts. You can do either with the same result ignoring any trading fees. However if you’re using equity options (like on SPY), the covered call will use a bunch of your cash. For that reason and for trading fee efficiency I’d prefer the naked put and would try to avoid assignment.

      I’ve been trying this short term put selling strategy for the last month or so. It’s been working quite well which makes sense as the market has more or less gone sideways. I have made money on every put I’ve sold. I’ve also thrown in a few short calls. But as an example of closing losing positions early, yesterday (Thursday) I had on options that I’d previously sold for ~$4 that were expiring today (Friday). The market dropped enough that almost all my options were in the money. One of those options went as high as ~$19. Others went up even more. Then the market reversed back up and finished the day unchanged. I ended up making a nice amount of money for the day. Today I closed all those options for a profit as the market moved up. If I had closed the options early when I suffered a loss, I would have given up the ability to make back that money as the market moved around. However it’s also possible I would have then sold new options at lower strikes in the next cycle which could have helped recover some of that loss.

      Liked by 1 person

      • Thanks John,

        I work at a big bank and looks like futures might be covered securities, so would have to go through the hassle of pre clearing all of them which wouldn’t really work.

        In lieu of the futures contracts though, can I synthesize that with cash settled index options?

        I looked at CBOEs website and there is the XSP which is 1/100 of the SPX so the same exact size as SPY.

        Since they’re cash settled, XSP would get the preferable 1256 Tax treatment of 60% long term and 40% short term cap gains.

        They’re also European style so won’t have to worry about it early assignment.

        If I’m thinking of this correctly, cash settled simply means netting the current index price vs the strike price at exercise date. So presumably wouldn’t I have the same leverage benefit as S&P futures and avoid the cash management issue that options on SPY present?

        Trying to think of a good workaround to futures and this seems like it might be it. Am I missing something?

        Liked by 1 person

        • You’re right that XSP is cash settled and thus has no assignment risk other than your position being converted to cash. There is no underlying stock to be assigned to you – you can only trade the options. I seem to remember the cash settlement has some oddities to it, but I’ve never traded it. However I personally would not trade it as the volumes in the options are really low and I would worry about the liquidity. I probably would have been in the 263 puts on Wednesday and the open interest is 60 contracts. Compare that to SPY which has about 20000 open contracts. SPX has 1550 open contracts and ES has 1300. The bid/ask spreads look equivalent to SPX and ES after adjusting for the notional value multipliers though (SPY looks a bit tighter). I suppose you could try trading it and see if it’s easy to get your orders filled near mid price.

          Also note that the margin is higher than for ES. It’s basically the same as for SPY at least in my portfolio margin account, or 2x the margin on ES. In a regular margin account it would be even higher. It think it would be ~3.7x the ES margin but I’m not 100% on that. You could still achieve 3x leverage but it would use more of your available margin.

          Liked by 1 person

      • Thanks! For some strange reason, a naked short put requires more margin than a long ES future.
        I think we have the same approach: simply close out the assigned ES future with a delta of 1 and replace with a new out of the short put with a delta much smaller than 1. THat’s what I do every week! 🙂

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    • If I get assigned (2-3 times a year) I’m usually so frustrated and risk-averse that I prefer not to have the high delta of a long ES plus short call (at the money or – even worse – out of the money).
      If I get assigned I close the ES contract, then sell another way out of the money put on the ES. Try to make the money back over the next weeks (sometimes months).

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  6. ERN,
    You mentioned that you’re writing on the MWF settled options now. Just wondering how our of the money are you targeting with those settling in 2-3 days vs the weekly settled?

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  7. Do you know where you could get historical data on the prices of put options contracts? I assume you could use the historical VIX, S&P 500 and T-Bills data to calculate the theoretical prices of the options using Black-Scholes, but I’m curious what was actually available in the marketplace? Thanks.

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