June 10, 2020 – Welcome back to another post dealing with an investing strategy that’s central to our own retirement strategy here in the ERN household. Just a bit of background: about 35% of our financial net worth is currently invested in this strategy. But it accounts for more than 50% of our taxable assets, so for our early retirement cash flow planning, this is really serious business. This puts food on the table in the ERN household!
The first three links are more about the general philosophy and the last link, Part 3, is about how I’ve been running the strategy most recently. The strategy involves writing (=selling/shorting) put options on the S&P 500 index with a little bit of leverage. And one can also keep the majority of the account in income-producing assets (bond funds, preferred stocks) to generate additional cash flow. Sweet!
In light of the recent market volatility, of course, it would be a good time to do an update on my strategy because I’ve gotten a lot of questions on how that strategy has been holding up during the bear market. Did it blow up? You are all a bunch of rubbernecks, aren’t you? 🙂
Long story short, my strategy did pretty well so far this year. Not just despite but even because of the volatility spike. Let’s take a look…
OK, before I even get into the weeds of the 2020 Bear market, let’s start with a few more general option topics that I always wanted to write about. They will also be a good rationale for some of the trading decisions that I made during the bad bear market of 2020.
One question I get frequently is this one:
What is the “Option Delta” and why is it so important to monitor?
In a nutshell, the option delta can be interpreted many different ways:
- Mathematically, it’s the derivative (slope) of the option price with respect to the price in the underlying, ceteris paribus (all else equal), i.e., while holding all the other parameters constant. In other words, the in the chart below, Delta is the green line and it’s first derivative of the blue line.
- Simply speaking it’s the sensitivity of the price of the option to changes in the underlying price, all else equal (i.e., implied volatility, risk-free interest rate, dividend rate, etc. all stay the same).
Side note: The Delta is also a rough estimate of the probability that the underlying will fall below the strike price (for put options) or rise above the strike price (for call options). For the math geeks, I included the derivation below:
As always, there are limitations:
- For very large market moves you can’t use the slope approximation anymore because the delta itself will change with the underlying (see the green line in the chart above). The rate at which the delta changes is measured by another option greek called gamma.
- Also, for very large market moves it’s not just the underlying price that will change but also the implied volatility. In other words, if the S&P were to fall by 100 points over a short period, your short put option position will lose a lot more than 100 times your portfolio delta, thanks to another other option greek: vega, the change in the option price due to changes in the implied volatility. And, yes, I know, “vega” isn’t even a Greek letter.
- But again, for small enough market moves, the Delta is a rough estimate of how much market risk I’m exposed to.
So, why is the Delta so important? I like to keep my account risk as constant as possible. I don’t want to have essentially zero exposure to the market on Tuesday and then bet the house on Wednesday. Monitoring my Delta is a great help in that task. And I can express that on the individual option level where the option Delta is normally expressed as a value between 0 and 1 (or -1 and 0 for puts). But I can also monitor the overall portfolio Delta exposure, aggregating over all options and also factoring the option multiplier (100x for the SPX index options and 50x for the e-mini futures options). In that case, it’s expressed in $ per SPX index points, i.e., if I have a portfolio Delta of 30 it means, my portfolio moves $30 for every SPX index point. Interactive Brokers provides that figure on the main portfolio overview page on their mobile app.
More info on option, derivatives, etc.: Since a lot of folks keep asking that same question about what option pricing reference book I use, here it is: Robert Whaley’s Book “Derivatives” (paid link). It comes with a CD-ROM that has an Option-Pricing Excel Plugin. The book is quite expensive (slightly over $100) but the Excel plugin alone is worth the money. Robert Whaley, by the way, is the researcher credited with developing the VIX index!
Most importantly, the Delta also helps me picking my strikes, which brings me to the next item:
What strikes do I target?
That’s probably the #1 question I get. Again, there’s some science, but also some “art” and “gut feeling” and maybe a little bit of luck involved in this process. There are (at least) 5 different methods to target the strikes based on science:
- Target a fixed yield. I try to shoot for an annualized yield of around 5%. I detailed the math behind that number in Part 3 of this series: with a leverage of about 2.5x and an annual yield of 5%, I’d generate maybe about 12% gross annual yield before losses and probably somewhere around 5% after budgeting for the occasional put option that goes in the money. Together with the yield on the fixed income portion of the portfolio, I’m targeting around 9% annualized return. In any case, if the index is at around 3,000, a 5% put option yield means your options should fetch around $150 a year (per index multiple). That’s just under $3.00 per week, so about a $1.00 premium Monday to Wednesday and Wednesday to Friday and probably a bit lower than $1 over the weekend. You may have three calendar days but only one trading day between the Friday and the Monday close, so you have to adjust for that!
- Target a fixed Delta. I like to stay at an option delta of around 5 or below. (For the purists, this would be a -0.05 delta for the put).
- Alternatively, I can also target a fixed Delta times SPX volatility. So, I would reduce the Delta whenever stocks become more volatile, so as to keep my portfolio risk, expressed as % or $, constant. If you recall, back in March, we had triple-digit moves in the S&P almost every day (and 1,000+ point moves in the Dow Jones) and a VIX above 80. So, during the crazy-high volatility period in March, I was writing puts with a delta wayyyy below 0.05, probably closer to 0.01 to 0.02 to limit the daily volatility.
- Target a fixed multiple of the most recent memorable daily loss. For example, if the most recent worst daily drop in the S&P was 80 points, I’d probably want to be at least 160 points out of the money for a two-day option.
- Target a fixed percentage below the current index level. For example, no matter how low the VIX may be, I’d never want to write a put within one percent of the current market value, at least not when I’m running this with 2.4x leverage.
In practice, I’d use a combination of all five criteria. And sometimes not all criteria can be satisfied all at the same time and then you’d have to make some compromises. That’s where you must go beyond the science and rely on experience and gut feeling. And a little bit of luck! 🙂
If you want to see an example of my recent trades, here’s a screenshot of my Monday morning (June 8, 2020) trading screen. I had already traded one option with a strike of 3,060, while the index was slightly above 3,200. The Delta is only -0.023 and the time value about 5.1%.
When do I sell the new puts?
That’s probably the second most frequent question I’m getting. For example, when I get up on a Wednesday morning and I have a bunch of contracts expiring that day at 1:00 pm (Pacific Time Zone!), then when do I sell the Friday options? Do I write them at 6:30am that morning nice and fresh at the market open right after I get up? Or do I wait until 12:59:59pm to write the new contracts to make 100% sure.
The answer: It depends. Of course! If my current options are still at risk of going into the money before market close, I’d be crazy to double my risk. And if there’s very little risk of crashing through my put strikes then I have much more leeway in writing the new puts already earlier that morning. And how do I measure how risky my current options are? You guessed it: through the option Delta! So, there’s another application of this option Greek.
Moving from the general options trading philosophy to how this whole process worked in 2020 so far:
How did the options trading perform during the 2020 Bear Market perform so far?
Long story short, the strategy performed as I would have hoped for. In fact, even a bit better than I had hoped. Aside from two very minor losses earlier in January, I suffered a significant loss on February 24 when my puts went about 40 points into the money. Ouch! Considering that I plan to make about $3.00 in premium per week I had just wiped out 3 months’ worth of option premia. Not the worst loss ever but nothing to be happy about!
Amazingly, after the Feb 24 loss, all my puts earned the maximum premium. And the reason is exactly as I’ve detailed in this series before; after a major loss, implied volatility and thus put option prices skyrocket. In other words, …
… insurance becomes more expensive when the house is already on fire!
Which in turn means I can sell my options far enough out of the money (strikes below the current index level) that even with the crazy market gyrations in March 2020 the index never went below my put strikes again. Sweet!
But 2020 was even better than that! Not only did I suffer no more losses, but I recovered the loss within a few weeks by mid-March already. No need to wait for 3 months! And I am now up for the year by about 4.5%. Pretty sweet! Of course, it was still a wild ride. Even though I eventually earned all my put option premia there were a few scary moments in between. For example, on Thursday, March 12, the S&P 500 dropped all the way to 2,480, -9.5% in one day. I had a bunch of options expiring on March 13 (Friday the 13th, oh, my!!!) with strikes between 2,250 and 2,450. But since the S&P stayed above those strikes on the expiration date I easily made all the money back on March 13. Whew!
So, how did I manage to boost my option writing revenue so significantly in March? It’s a combination of (at least) four factors:
- Sell at higher yields: after yields went through the roof I could have simply sold options with my proven and tested target yield. But if I can sell options 20% out-of-the-money over the weekend and make three times my normal premium, then, hey, I’ll take that money! I sold some contracts with a 1,700 strike in March! Crazy times!!!
- Sell more contracts: I strongly advise against jacking up leverage willy-nilly, especially during high-volatility periods. You’d potentially set yourself up for an OptionSellers-like wipeout. Never, ever raise your leverage when things are going against you. I occasionally raise my leverage when things are going in my favor, though. Here’s an example: I sold a batch of Monday options on Friday morning. The market goes up on Friday afternoon and I essentially made 80% of the premium already. I might as well sell a few more Monday options and also still keep the almost worthless close-to-zero-Delta puts. It looks like a risky trade, but I consider it manageable if the overall Delta is low enough.
- Off-day option writing: Suppose you wrote your Wednesday options on Monday. Tuesday rolls around and the market moved sideways or even up and I made most of the premium already on Tuesday. The same logic as in the previous bullet point works here again: with the Delta so low now, I would occasionally sell a few more options for the Wednesday expiration. I had a quite few occasions like that in March 2020 and made pretty good extra income with that.
- Same-Day option writing: Now, let’s go even more exotic! Imagine on a Monday morning, my options expiring that day are already essentially worthless. Instead of selling the Wednesday options on Monday morning, I would then first sell options that expire that same day. And then hold off selling my Wednesday options until later on Monday afternoon when all of my Monday options are “secure.” Extra income! Hey, I’ll take it, especially after the painful loss in February!
Related to the question of how to best recover from a substantial loss, I always get questions like this one:
Why not just keep selling puts at the last strike at which you lost money?
The idea here is that if you simply keep selling options with the last strike that went sour, you’ll eventually recover the loss. You just have to wait for the market to recover again, which it normally does.
But this is a really bad idea! Let’s look at an example where this approach would have backfired catastrophically. And I have to look back no further than February 24, 2020, when my put options with strikes around 3,260 went in the money by about 40 points. Had I kept selling puts at that 3,260 strike, I would have had a wild ride when the index went all the way down to below 2,200 intra-day on March 23. A loss of about 1,100 index points! You take a 40 index point loss, about 3 months worth of premia, and turn it into a loss worth multiple years worth of option premia. Ouch! Had you done that with any degree of leverage it would have likely wiped you out along the way and you never could have recovered after all. The classical Gambler’s Ruin Problem!
Selling at that same strike only works when you experience a quick turnaround. If the market keeps dropping as in 2020 or during any other Bear Market you’re not going to enjoy the ride! And the rationale is – you guessed it – tied to the option Delta again. When the index falls far enough below that 3,260 strike, then the Delta of that put option is essentially -1. That’s 20-times the maximum risk I normally want to take on. Looks like a bad idea to me!
How did the rest of the options trading account perform?
Now for the (slightly) bad news. As I detailed in Part 3 of this series, I’ve shifted over the portion of the portfolio that holds the margin cash to slightly riskier investments. More yield but also more risk. Well, that portion certainly underperformed this year. It’s still down by about 4% year-to-date which drags down the nice positive return from the put selling back to +0.06% as of June 9.
Well, I could have just stuffed the money under the mattress. But I also made a lot more money in prior years thanks to holding the higher-risk/higher-return assets as margin. With the overall portfolio (put writing plus bond funds and preferreds) I significantly beat the S&P 500 index return in 2014, 2015, 2018 and closely matched the index return in 2016, 2017, 2019 and 2020 year-to-date, all at about half the volatility. So, I’m not going to complain too loudly about getting hit in my preferred share portfolio this year. In the big picture, this is still a great strategy to generate income in retirement: great returns and much-reduced volatility relative to an all-stock portfolio!
So, to conclude, before 2020, my strategy had only been exposed to relatively mild volatility and the occasional correction but I’m happy to report that the pure option writing strategy also did very well in 2020 during its first bona fide bear market. Not despite but exactly because of the high volatility! Good to know because there will be more bear markets to come during a multi-decade retirement!
Update 7/1/2021: Min Max Charts for 2020 CY and 2021 YTD
I hope you enjoyed today’s options trading update! Stay safe out there and happy trading!
Please check out the Options Trading Landing Page for other parts of this series.
Title picture credit: pixabay.com