All parts of this series:
- Trading derivatives on the path to Financial Independence and Early Retirement
- Passive income through option writing: Part 1
- Passive income through option writing: Part 2
- Passive income through option writing: Part 3
- Passive income through option writing: Part 4 – Surviving a Bear Market!
- Passive income through option writing: Part 5 – A 2018-2020 backtest: Guest Post by “Spintwig” (plus a quick update on last week’s volatility)
- Passive income through option writing: Part 6 – A 2018-2021 backtest with different contract sizes: Guest Post by “Spintwig”
- Passive income through option writing: Part 7 – Careful when shorting long-dated options!
* * *
April 21, 2021
Welcome to a new installment about trading options. Alongside my work on Safe Withdrawal Rates, this is my other passion. In fact, on a day-to-day basis, I probably think about shorting S&P 500 put option much more than about Safe Withdrawal Rates. In any case, one of the most frequent questions I’ve been getting related to my options trading strategy is, how do you even get started with this strategy when you have a smaller-size account? Trading CBOE SPX options, with a multiplier of 100x on the underlying S&P index, even one single contract will have a notional exposure of roughly $400,000. I don’t recommend trading that without at least about $100,000 or better $125,000 or more in margin cushion.
How would one implement this without committing such a large chunk of money?
My options trading buddy Mr. Spintwig who already published another guest post in this series offered to shed some light on this question. He ran some simulations for my strategy using some of the other “option options” (pardon the pun), i.e., implementing my strategy not with the SPX index options but with different vehicles with a smaller multiple than the currently pretty massive 100x SPX contract. For example, the options on S&P 500 E-mini futures are certainly a slightly smaller alternative with a multiplier of only 50. And there are some even smaller-size contract alternatives, but my concern has always been that the transaction costs will likely eat up a good chunk of the strategy’s returns.
In any case, I’ll stop babbling. Mr. Spintwig has the numbers, so please take over…
Thank you Big ERN for another opportunity to collaborate on the topic of options selling! The formal backtest of your SPX 2-3DTE 5D M/W/F strategy was well received and generated lots of discussion.
One of the questions that keep coming up from that post is: “I want to implement the Big ERN strategy (or similar) but writing an SPX put option would generate too much leverage in my account. Are there notionally smaller instruments available that I can use and what are the implications of using them?”
Yes! There are indeed smaller instruments that have identical exposure. They are, in decreasing notional size:
- ES Futures (50x, 1/2 the size of SPX )
- SPY ETF (10x, 1/10 the size of SPX )
- MES Futures (5x, 1/20 the size of SPX )
Considering the S&P 500 index is trading at above 4000, then a single, short, at-the-money, or slightly out-of-the-money option contract with a 4000 strike will have the following notional exposure:
- SPX = 400,000 USD
- ES = 200,000 USD
- SPY = 40,000 USD
- MES = 20,000 USD
An entire post explaining the differences between these instruments can be written, and I’ll save that for another time. For our purposes today, we’ll focus on just one aspect: commissions.
Short option strategies that are far out of the money, defined as 5-delta or lower, generate a low amount of premium relative to higher-delta strategies. No worries though. On a hypothetical 5-delta 3700 SPX 0DTE short put, one might generate $200 in premium.
If it costs $1.32 in commission to open the position and we assume 55% premium capture over the long run (this is what Big ERN’s strategy averaged), commissions represent 1.20% ( 1.32 / [ 200 * .55 ] ) of the strategy income. Not bad. For context, most PayFacs (Square, Wave, Lightspeed, PayPal Here, etc.) charge between 2.60% and 2.90% + $.30 per transaction and direct merchant accounts are in the 1.8% range.
Suppose we do the same trade on SPY. SPY is one-tenth the size of SPX. A middle-of-the-road commission cost for SPY at the time of writing is $.70 for a single contract. All things equal, a comparable 5-delta 370 SPY 0DTE short put might generate $20 in premium. This represents a 6.36% ( .7 / [ 20 * .55 ] ) commission drag. That’s quite a bit more.
We can do this napkin-math exercise on each underlying, proposing hypothetical premium capture amounts, calculating commission drag, then call it a day. But that’s not how BigERN or I roll. Let’s do a formal backtest and explore each underlying, holding all variables constant except for commissions, and see what happens.
A few notes:
- Position count and premium received/paid are scaled to ensure consistent notional exposure across instruments
- Strategy Start Date is 2018-03-01 for two reasons:
- Monday-expiring weekly options on SPY were introduced on Feb 21, 2018 – see SEC release 34-82733. Prior to this date, the Big ERN strategy as it’s implemented today could not be executed.
- Mar 1 2018 allows for a clean comparison against the buy/hold benchmark.
- The simulation runs through March 2021.
- Tolerances around the delta target are used because there are few occurrences of exactly 5-delta positions. Despite the +/- 4.5D tolerance, all trades were +/- 1D.
- Max Margin Utilization Target: 50% | 2.5x leverage. Average margin utilization may be lower. This approximates the leverage Big ERN currently uses.
- Comprehensive details on how each stat is calculated can be found here.
- Margin requirements are always satisfied
- Margin calls never occur
- The margin requirement for positions is 20% of the notional
- Early assignment never occurs [ERN: they shouldn’t for the options on futures because they are European options, but theoretically, the SPY options could be assigned before the expiration!]
- Prices are in USD
- Prices are nominal (not adjusted for inflation)
- Margin collateral is invested in 3mo US treasuries and earns interest daily
- Assignment P/L is calculated by closing the ITM position at 3:46 pm ET the day of expiration/position exit
- Commission to open, close early, or expire ITM is:
- 1.32 USD per contract, all in, for SPX
- 1.42 USD per contract, all in, for /ES
- 0.70 USD per contract, all in, for SPY
- 0.47 USD per contract, all in, for /MES
- Commission to expire worthless is 0.00 USD per contract
- Commission to open or close non-option positions, if applicable, is 0.00 USD (think assignment)
- Slippage is calculated according to the slippage table; 0.5 = midpoint, 1.0 = market maker’s price
- Starting capital for short option backtests is adjusted in $100 increments such that max-margin utilization is between 80-100%, closest to 100%, of the max-margin utilization target.
Starting Capital and Leverage
The average daily margin utilization drifts higher across the strategies. As we’ll see in the below sections, this is due to fewer dollars being in the account due to the increased commission drag.
As expected, the win rates are identical across the strategies. There were 418 independent trades placed. Each trade ranged from 1 contract (SPX) to 20 (/MES).
Profit and Loss
Commissions as a percentage of total P/L range from 1.77% to 12.63% for SPX and MES, respectively. That’s a difference of over 7x.
Margin collateral is in the form of cash earning daily interest commensurate with the 3mo US T-bill. The greater commissions caused fewer dollars to be available earning interest. This resulted in a small but measurable ding to interest income. Your implementation mechanics may vary.
Again, metrics based on portfolio value are negatively impacted due to the increased P/L drag.
The >10% drag on CAGR between SPX and MES appears nominal. However, as the duration of the study increases the impact will become more apparent.
It’s difficult not to focus on the prospect of paying over 12.5% to do business. Retail brokers will love you, no doubt. Selling a home using a realtor is in the neighborhood of 6%. Credit cards that charge for currency conversions levy about 2.7%. But this ignores the other factors at play between these instruments which may offset costs.
Without going into too much detail, a trader would be prudent to understand the implications of:
- Option Style – American vs European
- Option Settlement – SPY stock, cash, or ES MES contract
- US Taxation Differences – short-term capital gains vs Section 1256 contracts
- Relative Liquidity – spread widths, fill quality, and ability to “get out”
- Hours Traded – 9:30-4:15pm ET vs near-round-the-clock
- Margin Requirements – Reg-T vs SPAN
Implementing the Big ERN strategy using notionally smaller instruments is viable but it may be more cost-effective to transition to a larger instrument if/when funds allow.
Back over to Big ERN for his thoughts and observations.
Thanks, Spintwig, for doing this! I’m positively surprised that my strategy involving so much trading activity (three trades a week) is at least mildly profitable even for some of the smaller contract sizes. I would not recommend running this permanently on such a small scale if the drag is more than 80bps p.a. But “getting your feet wet” and learning your way around trading options for a year or two until you move on to the “Big League” and running this with an SPX contract (or ten) with $150,000 in margin each seems like a path most readers can take. When I started with my strategy in 2011, the S&P was trading at only around 1,300 points, so the contract size was a bit more manageable (and I used the E-mini, 50x contract at that time). If I remember correctly, the initial margin was somewhere in the $5,000 to $6,000 range. I had it so much easier than all of you young folks out there! 🙂
Let me also add a few more thoughts on the return stats:
- I have generated slightly more profit with my strategy in real-time, likely because I do a little bit of extra market timing, i.e., scale up the trading volume when volatility is high or I notice some other attractive opportunities. For example, as I detailed in Part 4, I might initiate some additional trades when I see that my current short puts have a delta close to zero. This could be same-day trading (e.g., on Wednesday sell more Wednesday options if the current lot of options expiring that day are significantly OTM), or off-day trading (e.g., on Tuesday sell more Wednesday options if my current lot of Wednesday options already has a close-to-zero delta), and a few other techniques. Scaled to one short-put, I made just above $33,000 instead of the simulated roughly $27,000. So, you can potentially do a little bit better, albeit with the additional risk that comes with it.
- I also take a bit more risk with my margin cash. While Spintwig assumed about $5,400 in additional income from money-market-level interest in the margin account (close to zero for the most part), I’ve made much more with my strategy. See Part 3 of the series, Section 3: “Taking more risk with the margin cash.” Scaled to one short-put, I made about $25,000 in that 3-year time span. Yup, that’s not a typo, this is both from interest and dividends (5+% for the most part in tax-free closed-end fund Muni funds and 6+% in some of the Preferred Shares I own) and some capital gains because interest rates went down since 2018 and there has been a mad rush into everything yielding anything.
I just mention all this because some financially no-so-savvy critics will object “what’s the point of the strategy if you lag the stock market?” Granted, if you just start investing, you’re probably better off just going with the good old equity index fund. But once you get closer to FIRE and certainly when you live off your assets during FIRE, you are looking for less-volatile investments, especially investments with mild and shorter-lasting drawdowns to hedge against Sequence of Return Risk. I think this put option strategy fits very nicely into that niche and it’s exactly why my wife and I rely heavily on the income from the put options strategy in our own retirement. 4% annualized volatility, only about one-fifth to one-fourth of the S&P 500 looks pretty amazing! Of course, for full disclosure, by holding risker assets in the margin portfolio, we faced higher volatility. But achieving equity-like returns we still had only half the equity volatility. About 35% of our net worth currently funds our entire retirement budget. Pretty sweet!
Addendum: my current margin cash asset allocation:
This was requested from Mr. Spintwig in the comments section and I will post this in the main part because more people might be interested in this:
- 16%: Muni Bond Fund BCHYX
- 40%: Nuveen Muni CEFs: NMZ, NVG, NZF
- 7%: other Muni CEFs: BLE, BTA, IQI, MHD, MQY
- 33% Preferred: AHL PRC, ASRVP, ATCO PRD, BAC PRE, C PRJ, CUBI PRC, GS PRJ, KEY PRI, MS PRI, PBCTP, PNC PRP, RF PRP, RF PRB, SCE PRK, WFC PRQ, ZINO
- 4%: cash
Most of the Preferreds have variable rates (but some are still in fixed-rate mode and will transition to variable rate linked to LIBOR later). Most are non-cumulative.
Hope you enjoyed today’s post! Looking forward to your comments and suggestions!
Title Picture Credit: pixabay.com