October was a scary month for stocks: the worst monthly S&P 500 return in seven years! And November is off to a volatile start as well! We haven’t even seen a real correction yet but apparently, the drop was bad enough for me to got inquiries from friends and former colleagues asking how I’m doing with our portfolio and if (and when?) I’m going to come back to the office again! Sorry, not anytime soon! As I detailed in the post two weeks ago, we are not too concerned about one month of bad returns early in retirement.
Some friends and readers of this blog were specifically concerned that my options trading strategy might have been hit badly by the wild swings. After all, I’m doing this with a little bit more than 2x leverage and with the market down about 7% does that mean we lost more than 14%? Of course not! To all the rubbernecks out there who suspect we had a bad car wreck in our portfolio last month, I’m happy to report that we actually made a small profit with this strategy in October! And continued to do so in November! How awesome is that!? Well, there were a few close calls but I was able to escape any major damage. It took some Houdini Skills (or luck???), hence the title image of escape artist Harry Houdini (Picture Credit: Lomography).
Let’s take a look at the details…
Recap: Selling naked put options
As I detailed in the two option trading posts a long time ago (see Part 1 and Part 2), selling naked put options means that we are (voluntarily) exposed to the least attractive return profile; unlimited downside and limited upside potential. Because not many financial actors want to tolerate that and because there is a huge demand for downside protection (buying long puts) from other investors, there has been a pretty persistent “insurance premium,” meaning that folks pay significantly more for a put option than its expected payout. This has been thoroughly documented, see for example a nice piece from the CBOE on how a put selling strategy has superior risk/reward characteristics than the underlying passive S&P500 index investment.
What I particularly like about the put writing strategy is that we can make money in sideways moving market, even slightly downward sloping markets. True, we give up the upside potential! But being retired we are no longer in the game of trying to hit home runs because we became financially independent (FI) a long time ago. But we definitely enjoy the more stable income from option writing, i.e., the fact that we can cushion the equity downside with the option premium, see chart below. This is for an unleveraged short put at-the-money i.e., strike price at or close to the current value of the underlying:
In practice, I implement the strategy with (at least) three little twists:
- I sell “out-of-the-money” put options, i.e., those with a strike below (often significantly below) the current value of the underlying. This gives me enough “breathing room” in case the index goes down. Comes in very useful in a month like October 2018! 🙂
- I use leverage because the yield of the out-of-the-money options is obviously lower than the at-the-money options. But the risk is also lower, so I am comfortable with a little bit of leverage!
- I do this with the shortest possible horizon: Since there are three expiration dates every week (Monday/Wednesday/Friday), I sell options every M/W/F with the closest possible expiration day (W/F/M). For example, on Fridays, I would write options expiring on Monday, only one trading day after! On Mondays and Wednesdays, I sell options with just a two-day expiration on Wednesday and Friday, respectively.
Now the relative return profile looks a bit more complicated, see the chart below.
Now one can lose more than the index (region 1), but only if the index suffers a pretty significant loss.
Show me the numbers! How did we do in October?
Let’s look at our cumulative return chart below:
There was one big drawdown in early October, causing about a 2% loss for the month. But there was a swift recovery back to just above zero on October 12, more on that later! But apart from that, the P&L chart is one nice straight line up. We were up by about 1.03% in October and another roughly 0.6% in the first two weeks of November (as of November 16). Not a bad return profile especially when compared to the S&P500, see the chart below:
It looks like the small drawdown in early October correlated with the big drop in the index on October 10 and 11. But while the S&P500 recovered only a small fraction of the losses on October 12 and stayed down 5% for the month we were able to jump back into positive territory! Beautiful!
How is it possible to make money if the market is down so sharply?
Very simple! The market was down but never dropped much below my strikes. In other words, going back to the put option return diagram above, for the most part, we were in region 3 “Profit while the benchmark loses” and only once we got briefly into region 2 “lose but less than the benchmark.” Never into the dreaded region 1 “Lose more than the index.”
As scary as the month of October may have been, the meltdown happened relatively gradually. Sure, there were a few days with drops of 1% and more, even two 3+% drops on October 10 and 24. But none of the sharp declines happened out of the blue like the scary February 5 meltdown earlier this year. Or the Chinese devaluation in 2015. In other words, the fear of a large stock market decline had already been priced in! The VIX (fear index) was already sufficiently high and it means that I was able to sell options with strike prices far enough out of the money that even the big declines didn’t pose too much of a risk.
How far out of the money? Let’s look at the time series of the S&P500 index vs. the strikes of the put options I sold, see the chart below. I plot the E-mini futures contract prices at 4:00 p.m. Eastern Time (gray line) versus the strikes of my puts. Sometimes I sell options at only one single strike price, but most of the time I sell at a range of different strikes, so, I plot the minimum and maximum put option strike. Notice that when the big jumps occur in the strike prices, it’s because the old options expired and I rolled into a new set of options every Monday, Wednesday and Friday. In any case, according to this chart, the index only dropped below my strikes once around October 11 and 12. The rest of the time we always made the maximum profit, which explains the cumulative return chart going up so smoothly most of the time. But even on October 12, when we ended up only slightly underwater, “only” half of the options lost money and the other half expired worthless (maximum profit for us).
Small technical note: The index line in this chart is the S&P500 closing value at 4:00 p.m., (when the options expire) adjusted by a small margin (1 to 2 points, to account for the small difference between the futures and spot price). I do have the E-mini S&P500 futures closing prices, but only at 4:15 pm, a 15 minutes after the options expiration time. But for this exercise, I needed the price of the ES Future at 4:00pm.
Even the October 12 loss could have been prevented!
There was one occasion in the entire time span where I deviated (slightly) from my usual strategy. On October 8 (Monday) I sold puts with strikes ranging from 2,745 to 2,785 with an expiration on October 12 (Friday) instead of October 10 (Wednesday). Why? Because I knew we will on a flight from San Francisco to Seoul, South Korea on October 10, (part of our epic 7-month, 20+ country world tour), landing right around the options expiration time. The plane ended up landing just on time, so I could have actually rolled the contracts that day, i.e., let the Wednesday options expire worthless (the index closed just above the highest strike price of 2,785) and sell the Friday options with a much lower strike due to the spike of implied volatility. But I didn’t know that in advance and I didn’t want to bet on the plane landing on time. If there had been any delay I would have been afraid about having options expiring in the money while I’m still in the air, flying somewhere over Vladivostok, Siberia. Of course, Murphy’s Law struck and in hindsight, it would have been better to roll on Wednesday. Well, you win some, you lose some! Luckily, half the options expired worthless (=maximum profit for me) and the other half was in the money by only a few points. So, instead of wiping out a month or two of option revenue I “only” lost most of the income month-to-date.
But make no mistake! It was a scary month!
Kicking myself about the bad timing of the October 12 options wasn’t the only unpleasant experience. There were a few occasions of what I call “point landings,” where the equity index future dropped to within just a few points to our highest strike price. You make the maximum profit for the option but you came so very close to losing money:
- On October 5, the index finished at 2885.57, the futures at maybe 2 points above that. That was the closest call in a long time with my strikes at 2885! Watching the last few minutes of trading that day was a bit like watching a basketball game in overtime! Never a dull moment in the ERN household!
- On October 24, the index finished at 2656.10 after a late-session sell-off. Futures at around 2658, which is just 8 points above some of the strikes of my short puts! Close call!
- On November 12, the index finished at 2726.22, the futures at around 2727.75, which is still comfortably above my highest strike of 2715. But a few minutes before the close, the S&P got dangerously close to my strikes. I was sitting at the breakfast table on the cruise ship, getting ready to get off the ship to explore Lifou, New Caledonia, but couldn’t really enjoy the food so much because I was glued to the screen and “cheering” for the ES E-mini contract to stay above 2715!
So, in other words, even though the return profile looks really nice in hindsight, the last one and a half months weren’t exactly a walk in the park! I’m just saying this to make clear that selling naked put options is not some kind of magical money-making machine. It takes some stomach to run this strategy successfully in the long-run! In fact, human nature is naturally very opposed to this extremely negatively skewed return profile, as I pointed out in a post last year: “We are so skewed!” If anyone wants to replicate what I’m doing, please start with a small account and some “play money” to see if this works for you!
So much for today’s status update on my options strategy. Sorry if this post got a bit technical! Maybe the normal ERN blog audience didn’t get much out of this post but I wanted to write a post for my option trading honchos (Bob Jane, John, etc.) with some additional details on how we did during this crazy time! Good luck everybody, embrace the volatility!
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Picture Credit: Lomography