Passive income through option writing: Part 3

Back in 2016, I wrote a few posts on trading derivatives, especially options, to generate (mostly) passive income:

I’m still running that same strategy but it definitely evolved quite a bit over time. This might be a good time to write a quick update on what I’m doing and what I’ve changed since then. And for everyone who’s wondering what’s the use of this: I’m planning a future post on how selling options may help with Sequence Risk, so this is all very, very relevant even for folks in the FIRE crowd!

So, let’s take a look…

A quick recap

Selling put options exposes me to the worst possible return profile: I have (almost) unlimited downside risk, i.e., if the price of the underlying drops below the strike price then I lose the difference between the underlying and the strike price. But I have only limited upside potential; even if the underlying goes up by 100% (which is unlikely with an index over a short time frame, though) I only make the option premium, see the chart below:

putwriting-payoff-diagram2
From my earlier option post: A short put option gives you a cushion when the market drops but it limits your upside potential. If the premium is high enough this can be a highly profitable and low-risk “investment!”

Most people think that the return profile sounds unappetizing. It’s exactly the opposite of what most investors desire: unlimited upside and insurance against dramatic losses (positive skewness). But here lies the strength of this put selling strategy: Since it’s the opposite of what everyone desires the option premiums tend to be higher than the “fair” market price. It’s like a casino: people who frequent the casino pay a small fee to play and have a small probability to win a big payday (=buyer of an option) but the truly profitable business is being the casino (=selling insurance) not gambling in the casino! Same logic with the lottery. Or buying an extended warranty. Or buying insurance. It’s profitable for the sellers of those services!

So, show me the money! How would this strategy have performed in the past? Selling puts on the S&P 500 would have performed pretty well over the last few decades. You would have even outperformed (!!!) the index since 2000, see the chart below. Well, the recovery post-2009 would have been better with the S&P 500 index, but over the longer horizon, two bear markets and two bull markets, the put selling did phenomenally well!

PutW chart01
Cumulative (nominal) returns of the S&P500 (total return) vs. writing at-the-money put options once every month. Source: CBOE, see here and here for the source data.

Now, I don’t want to stress the outperformance of the put writing strategy too much. That’s because even performing in line with the S&P 500 or even slightly underperforming the S&P would have still been pretty impressive. What is truly amazing about the put writing strategy is that you generate equity-like returns but you do so with:

  1. roughly one third less volatility (~10% annualized vol, compared to about 15% in the S&P 500)
  2. significantly smaller drawdowns (i.e., drops below the all-time-high up to that point), and
  3. shorter-lived drawdowns, see the chart below:
PutW chart02
Drawdowns are much more shallow and shorter-lived when writing puts. This is much preferred from a sequence risk perspective!

That’s a huge advantage from a Sequence Risk perspective! That’s why I think selling options is a great strategy, especially for (early) retirees! If you’re still very early in the accumulation phase, sure go ahead and go crazy with equities. As I showed a few weeks ago, even a (temporary) drop in the stock market can be beneficial in that situation. But if you’re in retirement or close to retirement you’re much more concerned about Sequence Risk! So, in a previous post (Part 2), I detailed what exactly I am actually doing in my portfolio, which is slightly different from the simple short put strategy benchmark published by the CBOE:

  1. I sell puts that are “out of the money,” i.e., with a strike price a bit below today’s underlying value. The premium is a bit lower than for the at-the-money options but so is the volatility.
  2. I use some leverage to overcome the lower premium revenue.
  3. I use shorter-dated options.
  4. I invest the margin cash in higher-yielding bonds and also more tax-efficiently (Muni bonds). The CBOE PUT index assumes you invest the margin cash at a short-term (e.g. money market) rate.

But since I first wrote about this, here are some additional updates:

1: The account size is much larger!

When I first wrote the option trading posts in 2016, I already ran this with a six-figure account size. Not exactly “play money!” But that account has now grown substantially, due to both capital gains and additional contributions. Now the options trading account is about 35% of our total financial net worth, and about half of our financial net worth outside of retirement accounts. In other words, assuming that we don’t touch our retirement accounts until I turn 59.5, the put writing strategy now has to carry half the weight of generating income in retirement. And just in case you wonder, no, this blog does not in any material way contribute to our retirement budget. So, this is the real deal, not some academic exercise! This is what we actually use to finance our early retirement!

2: The leverage is lower, the premium target & option Delta is lower, and the “loss allowance” is larger

Retirement, especially early retirement, plays tricks with your mind! Suddenly, you become much less comfortable taking risks. So, when you run this strategy with some serious pile of real money and also without a day job to make up for potential losses you get a lot more cautious:

Leverage: I used to run this with roughly 3 to 3.5x leverage. Now I’m down to around 2 to 2.5x leverage. And again, there was some confusion about what exactly I mean by leverage. It’s very straight-forward to calculate your leverage ratio when you’re buying an asset. You have $100, you get a $40 loan and purchase $140 worth of assets. Your leverage is 1.4x. But how do you do this when you’re shorting a derivative? My preferred method is as follows. If I sell a put option with a 2,800 strike and a multiplier of 100 then the notional value is $280,000, also equal to the potential loss if the market were to drop to zero. If I have $125,000 per short option in my portfolio then the leverage is $280,000/$125,000=2.24. Notice that the $125,000 is about 5 times larger than the minimum margin requirement mandated by the exchange (roughly $25k). It’s always a good idea to keep way more margin cash as a cushion to avoid becoming a victim of margin calls, which is what wiped out the hapless OptionSellers.com investors.

Premium Target: The further out-of-the-money you write your put options the lower the premium. But the risk of losing money is also lower. So, I currently target an option time value of around 5-5.5% p.a., a little bit lower than the 7% I quoted in my posts from 2016. And again, the way I calculate this percentage is the annualized premium divided by the notional value. So, if I can make a $300 option premium per week and the notional value of the option (multiplier times strike) is $280k, then the time value yield is about 52×300/280000=5.57% (for an unleveraged position). The gross return is obviously larger once we apply leverage!

Also, different option traders use different methods to pin down their strikes. Delta or how many standard deviations (sigmas) you want to be out of the money. My strategy of targeting a certain yield is very close to targeting a 5 Delta or around 1.5-2.0 standard deviations below the current index level. Not every single transaction but over long-term averages.

Loss Allowance: I used to budget a loss allowance (i.e., how much of my gross premium revenue I lose – on average – when options go into the money) of around 50-55%. I’ve increased that to 60%. So in other words, out of every $100 of gross option revenue I budget I’ll keep $40. 2018 was my worst year so far, but I still managed to stay close to the 40% profit margin even after that horrendous February volatility spike. The overall average since 2012 was indeed 55% but, again, out of an abundance of caution I want to budget only 40% profits.

PutW chart03
Actual profit margins from selling puts 2012-2019. Note that in 2019 I haven’t suffered any loss (yet)! I wonder how long that’s going to last!? 🙂

So, what’s my expected option trading return? Simple Math. Let’s assume 2.25x leverage, 5.25% option yield and 60% loss allowance. I’d generate a net profit of 2.25×5.25%x(1-0.6)=4.725% annualized return. What? All this effort for such a measly return? Aren’t we supposed to earn 12-18% from investing in stocks? Hold your horses. First, your expected return from stocks isn’t 12-18%. Consult Dave Ramsey to get out of debt but fire him as soon as you get to a net worth of zero and listen to people who actually know finance to grow your assets! Second, the option revenue is only part of the equation. The beauty of the option writing strategy is that this is all done on margin! So, in other words, for every short Put option you also have another, say, $125k lying around to “play” with, i.e., to generate extra income. Theoretically, you could even invest that $125k in your standard 60% Stock, 40% Bond portfolio and use the short puts to make an extra 4.7% p.a. in addition to your 60/40 portfolio! For my taste, though, that would be loading up on equity risk a little too much. Especially considering that I already have tons of equity holdings in our other accounts. So, I keep my margin cash in a more stable portfolio. But since I first wrote this post I’ve certainly gotten a little bit more adventurous with my margin cash, which brings me to the next item:

3: Taking more risk with the margin cash

When I first wrote about this topic, I held most of the margin cash in Muni Bonds mutual funds. I have since transitioned over to a slightly more adventurous (=riskier) allocation

  • Muni Bond Funds (e.g. ABHYX): 30% of the portfolio. The yield is pretty decent! About 3.5% p.a. and that’s all tax-free!
  • Muni Closed-End Funds (e.g. NZF, BAF, etc.): 40% of the portfolio. These pay just above 5% in (tax-free!) interest. This comes at a cost, though: They are much more volatile (due to leverage!) than the lower-yielding plain-vanilla muni bond mutual funds.
  • Preferred Shares (e.g. ALLY-PA, GS-PK, MS-PI, STT-PG, etc.): 25% of the portfolio. All my preferred shares are floating-rate (or at least currently fixed, then transitioning over to floaters at a future date) to hedge against the risk of eventual interest rate hikes. Currently, the weighted average yield is just about 5.75%. Most of this is treated as (qualified) dividend income, though some also pay ordinary interest. The issuers may be very solid companies but make no mistake, Preferred Stocks are quite a bit riskier than your typical bond. They are called preferred stocks, not preferred bonds!
  • Cash balance: 5% of the portfolio. Interactive Brokers pays around 1.50% interest on unused cash balances and this is obviously ordinary income.

The weighted yield on all of the above is just about 4.6% p.a. Not too shabby! So let’s call that a 9% total return for the whole shebang; options plus margin cash returns. Subtract 2% inflation expectations and we’re at 7%. Not that bad! It’s in the same ballpark, even a little bit higher than long-term equity returns (6.7% real return) and much more than what I would expect conditional on being 10 years into a bull market. And the option strategy has lower volatility and better-looking drawdowns than equities! Case in point, October through December 2018 when I actually made money with this!

Also, I’m fully aware of the irony here. Over the last few weeks, I just finished my mammoth project, analyzing (mostly dismantling) the “Yield Shield” strategy. In case you’re not familiar with this, some other bloggers proposed the Yield Shield to eliminate Sequence Risk by investing in higher-yielding assets (spoiler alert: it doesn’t work!!!). But please note the big distinction here: I increase the yield in the fixed income portfolio knowing very well that this also increases Sequence Risk. I have no illusion (delusion?) that this would ever help with Sequence Risk. But I believe that the option-writing strategy actually has lower sequence risk than a plain equity portfolio so I can afford a little bit of extra sequence risk from my preferred shares.

4: Trading SPX options instead of S&P500 E-mini futures options

Over the years, people asked me why I would trade the futures options and not simply the SPX index options. Simple answer: while working in my finance job, that was the only asset class I was allowed to trade without preclearance from the compliance department. And by the way, my former employer was incredibly generous because I know a lot of friends at other banks that were strictly prohibited from trading any derivatives products (index options, futures, futures options). So, in any case, after leaving my job I eventually transitioned over to trading SPX options and never looked back because there are numerous advantages:

Lower commissions

One ES contract (50x) costs $1.42 in commission. That’s $2.84 for the equivalent of a 100x SPX contract. I pay a commission of around $1.24 per SPX contract. That doesn’t sound like a big difference but trading three times a week, this adds up to around $250 a year. It may not sound like a huge deal but considering that I budget around $13k to $14k in gross revenue per year from one single short put option and about $5,000 in net revenue (after paying for the occasional losses when the short puts expire in the money), then an additional $250 in fees per year is just too much!

Better margin efficiency

Both instruments, ES puts and SPX puts require around the same amount of margin. Roughly $12,000 for the ES put and $25,000 for the SPX at twice the size. But the SPX options are more margin efficient in the following sense:

I can use my Muni bonds funds, ETFs and Preferred shares as collateral for my SPX options. I’d keep a pretty slim cash cushion (maybe around 5%, or $6k out of a $125k of margin cash per option) ready to deal with a 60-point in the money loss. But I can keep the overwhelming majority ($119k) of my margin cash in income-producing assets, see top panel in the table below.

Not so if I held short ES futures puts. Interactive Brokers maintains two subaccounts, one for “securities” and one for “commodities.” If you hold short ES Futures options, IB will move over the margin requirement into the commodities subaccount. This could create a negative cash balance in your securities subaccount (see middle panel) if you hold too much of your margin cash in ETFs/MFs. That raises two issues: 1) you’ll start paying margin interest and 2) the IRS rules that your income from ETFs and MFs is no longer tax-advantaged (either tax-free or ordinary dividends) but “payments in lieu of dividends” which are considered “ordinary income” for income tax purposes! I guess the IRS doesn’t like it when people buy tax-advantaged assets on margin.

The only way to avoid the negative cash balance is to hold less money in ETFs and mutual funds, see the bottom panel. But that also lowers your income potential from the margin cash! One of the reasons why I prefer SPX options over the ES put options!

SPXoptionsMarginEfficiency
Because SPX index options are domiciled in the “US Securities” subaccount, the same as my Mutual Funds, ETFs, etc., I need very little idle cash sitting around to satisfy my margins. ES Futures options require more idle cash to satisfy margin requirements!

The convenience of cash-settled options

If the ES options end up in the money I will then end up with a long ES futures position in my account (=physical delivery). The only exception is the third Friday of March/June/September/December when the puts expire exactly on the same date and the same time as the underlying. So, with futures options, it’s my duty to sell the ES Future if short options get exercised. In contrast, with the SPX options, I simply see a debit for any option that ends up in the money. There are two advantages to cash-settlement. 1) I avoid the cost of getting rid of the long ES future and 2) I don’t have to sit front of my screen at exactly 1pm Pacific time and make sure I don’t end up ES futures (at 2.5x leverage!) right around market close. What if I miss that and the ES futures keep going down in after-hours trading? What if I have a medical emergency and I end up in the hospital and I can’t get rid of the leveraged futures position for a few weeks? The cash-settled SPX options are much easier to handle!

The only disadvantage: shorter trading hours

The only disadvantage of SPX index options is that they trade only during market hours (9:30am-4:00pm Eastern time on weekdays) while the ES future options trade even outside of market hours. You can even start your trades on a Sunday afternoon (Pacific time). But I’d never do so anyway because there’s normally very little liquidity outside of NYSE trading hours. Even when trading ES futures options I’d do so during normal trading hours 99% of the time. So, for me personally, it’s not a real disadvantage at all!

5: Trading three times a week (and sometimes four!)

When I initially wrote about this strategy I would sell options every Friday with an expiration the following Friday. Currently, I write options three times a week for the expirations on Monday/Wednesday/Friday. In other words, every Friday, I sell options expiring on Monday. Then every Monday I sell options expiring on Wednesday and – you guessed it – every Wednesday I sell options expiring on Friday. And if the last trading day of the month falls on a Tuesday or Thursday you get another expiration that week for a total of four trades that week!

There are (at least) two advantages to writing shorter-dated options. First, you have a lower probability of getting dinged by a sequence of bad days. Some of my worst losses with this strategy came when the S&P dropped four or five days in a row (think August 2015, January 2016, December 2018). With shorter options, you have the potential to avoid the big losses because you constantly “roll” your options and sell at new strikes. If the market is in a rut and keeps going down, you also move down your strikes over time. This helped me to actually make money in Q4 of 2018 because the S&P 500 fell “slowly enough” to almost never breach my strikes!

HitByMomentumChart
Writing shorter options is a hedge against a sequence of bad-luck shocks. In the top panel, we wrote an option with 4 trading days to expiration. The market drops three out of four days and we get to $13 in the money after day 4. In the bottom panel, the index stays above the strike of the option after two days. But due to the drop (and the likely rise in implied volatility), we can sell the next option with a far lower strike and avoid getting dinged from a continued fall in the index! The index dropped but we made money with both options. Sweet!!!

The second advantage is that more independent bets imply that the Central Limit Theorem has more power to work! Huh, what does that mean? As I previously wrote, selling put options generates a very (negatively-)skewed return profile: limited upside and unlimited downside, i.e., the kind of return profile that nobody wants because it’s so much at odds with most investors’ preferences that are biased toward positively-skewed returns! But even the most badly-behaved statistical distribution becomes more and more Gaussian-Normal (that nice, symmetric bell-shaped distribution) if you average over a sufficiently large number. Here’s a little numerical example:

Imagine you earn an option premium of $1 and with probabilities, 95%, 4%, 1% the option value at expiration is $0, $5 and $30, respectively. So, you earn $1 with 95% probability and you lose $4 and $29 with probabilities 4% and 1%, respectively. That’s a very negatively skewed distribution. If we simulate 20,000 samples of the average returns over 1, 10, 50 and 500 draws then the distribution of average returns over those 1, 10, 50 and 500 draws becomes more and more Gaussian-Normal, see below:

CentralLimitTheoremChart
Even a skewed distribution looks more and more Gaussian-Normal when you average over enough independent observations! 20,000

So, even a very unattractive and negatively-skewed distribution becomes better-behaved if you diversify over time. The more independent bets you can take the less scary the average distribution will look like! That’s why I try to take as many independent bets as possible, i.e., I use the shortest possible time to expiration to maximize the number of tries every year!

10_DM_Serie4_Vorderseite
Don’t you miss the old 10 Deutsche Mark note? It had a picture of Carl Fridrich Gauss and a small figure with the Normal distribution named after him! Source: Wikimedia

Of course, there are also (at least) two disadvantages of trading more frequently. First, it’s more work. Well, is it really? I’ve never timed exactly how long it takes me to do my trades every Monday/Wednesday/Friday. But last week we went skiing and I did my option trades on my Android phone while sitting in the chairlift for a few minutes. It’s not a huge time commitment! Of course, being a total finance geek I spend way more time in front of the screen looking at finance charts. Some people follow the Kardashians. I follow the S&P500 and VIX! But it’s not for everyone!

MVIMG_20190320_132851
Sitting in the chairlift and enjoying the view (Mt. Hood, Oregon’s tallest peak in the background). And doing a few SPX option trades on my Android phone, too!

The second disadvantage is that you have more chances to get “whipsawed.” It’s basically the opposite of the bad, bad, bad weeks mentioned above. Imagine the index goes down on Tuesday and Wednesday and breaks through your strike price. You lock in your loss on Wednesday only to see the index recover on Thursday and Friday. But when the index recovers you only recover the option premium, which may be way lower than the loss on Wednesday. I consider it the cost of doing business and I much prefer it over sitting through the scary negative momentum events like February 2018 or December 2018 with long-dated options!

HitByMeanReversionChart
Hit by Mean-Reversion: Sometimes you lock in the loss with the shorter-dated options. If the market reverts quickly you would have been better off selling the longer-dated options!

Side note: I’m not saying that this is the only way of doing this. A reader of this blog recently put together a nice all-in-one how-to post on how he intends to implement the options trading strategy.

Conclusion

This might be an exotic topic for the fans of the Safe Withdrawal Math posts. But I’m not a one-trick pony, so please bear with me! Also, I’m a big fan of put writing mainly because I think it has the potential to alleviate Sequence Risk. Not eliminate it, just alleviate it! So, stay tuned for a future post where I’d plan to combine the crazy exotic options trading stuff with the more mainstream FIRE, “how-to-deal-with-Sequence-Risk” stuff!

Hope you enjoyed today’s post! Please leave your comments and suggestions below!

Picture credit: Pixabay

270 thoughts on “Passive income through option writing: Part 3

  1. No, there are actually only two cases! For the most part the Premium was so small on the expiration day that I simply went to bed. The probability was then 0.0X percent. I think 2 times it ran against me or at least not for me – so that I took some premium but the loss chance was still present (personal assessment) – then I bought back the option and directly sold the next one… small Profit – I traded most of the time at 11 PM local time anyway due to the low premium … at the weekend I go home again

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.