May 3, 2021
Welcome back to a new installment of the options series! In the discussion following the previous post (Part 6), a reader suggested the following: In recent history, the index has never lost more than 50% over the span of one year. Then why not simply write (=short) a put option, about one year out with a strike 50+% below today’s index level? Make it extra-safe and use a strike 60% below today’s index!
So, let’s take a look at the following scenario where we short a put option on the S&P 500 index slightly more than a year out and with a strike about 60% below the current index level:
- Trading date: 4/30/2021
- Index level at inception: 4,181.17
- Expiration: 6/16/2022
- Strike: 1,700 (=59.2% below the index)
- Option premium: $11.50
- Multiplier: 100x (so, we receive $1,150 per short contract, minus about $1.50 in commission)
- Initial Margin: $4,400, maintenance margin: $4,000
In other words, as a percentage of the initial margin, we can generate about 26% return over about 13.5 months. Annualized that’s still slightly above 23%! Even if we put down $15,000 instead of the bare minimum initial margin, we’re still looking at about 6.8% annualized return. If that’s a truly bulletproof and 100% safe return that’s nothing to sneeze at. A 6.8% safe return certainly beats the 0.1% safe return in a money market, right? Does that mean we have solved that pesky Sequence Risk problem?
Here are a few reasons to be skeptical about this strategy…
Problem 1: During the Great Depression, the index lost 70% over a 12-months window!
If we extend the range of the chart to include the Great Depression, we notice that there was indeed a 12-month window where this strategy would have lost a lot of money and probably would have wiped out the account after 1 year. The S&P lost a staggering 70.1% between June 1931 and June 1932! And there was another 50+% loss later that decade. I am not saying that we have to fear another Great Depression right around the corner. But a once-in-a-hundred-year event that can wipe out the entire portfolio is certainly something to worry about. Recall that if you make 6.8% every year for 99 years and then lose 100% in one year, the average return is not 5.8% (6.8%*0.99-100*0.01) but it’s compounded via [1.068^99*0]^0.01-1=-100%. One single accident like that can wipe out an entire century of gains! It’s less of a problem when that happens after 100 years when I’m already dead. It’s more of a problem if that accident happens over the next 30 years. A 30% risk of blowing up the portfolio over a 30-year horizon is not acceptable!
Problem 2: That pesky Option Delta (again!)
The false advertising in this strategy – as well as a lot of similar “easy money” option strategies that are marketed (shilled?) to unsuspecting retail investors out there – is that because we are (somewhat) certain that the index will stay above the strike on the option expiration date we will also have a smooth ride along the way. Nothing could be further from the truth! To understand why this is really dangerous logic, look at the following analogy. I once took a flight from Atlanta to Zurich, and the weather in Atlanta was nice and the weather forecast for the destination was mostly sunny. That didn’t prevent bad weather along the way, including several people around me filling up their barf bags. Some more than once!
So, how susceptible are we to “bad weather” with this short put option? One gauge (not the only one, see below for more details) is to look at the option delta. The option delta is the slope of the option price with respect to changes in the underlying, all else constant. It can also be understood as a very rough approximation of the market-implied probability that the underlying drops below the strike (see Part 4 for the details). I calculate the Delta of this particular option as -0.01464. Thus, a 10-point drop in the S&P 500 index, all else equal, will likely result in an increase of $0.1464 in the option price. And thus a $14.64 loss in your short option position (100x multiplier).
Thus, a 0.24% drop in the index will still cause a drop in your portfolio by about 0.1% if you keep $15,000 in margin cash. You are still holding a portfolio that is subject to market volatility. The claim that you can generate 6.8% completely risk-free goes out the window!
Also notice that if you only hold the initial margin requirement of $4,400, then a $14.64 loss is now 0.33% of that portfolio value, and thus your options portfolio is indeed more volatile than simply holding a 100% S&P 500 index portfolio. What’s more, because you have only a slim margin cushion of $400 ($4,400-$4,000) it takes only a 273-point drop in the S&P index (=10*400/14.64) for you to get a margin call, which means the exchange would liquidate the position unless you contribute more money and bring your account back to compliance with the margin requirements.
Of course, people will now object that the risk of a margin call is much reduced if you simply hold about $15,000 in margin cash. But even that is based on flawed logic, which brings me to the next point:
Problem 3: The other Option Greeks!
Someone who understands the “Option Delta” and only the Option Delta might get a false sense of security with the calculations above (Dunning-Kruger Effect). The problem with the Delta calculation is that it is valid only as a local linear approximation, i.e., for relatively small shocks to the value of the underlying. That’s because the Delta itself will change as the underlying moves (Gamma effect) and when the market drops we also observe a boost in the implied volatility of the option (Vega effect). Both the Gamma and the Vega effect will boost the price of the put option and thus your losses when shorting it. And a large enough stock market drop in the first month alone can still wipe out the entire account, even if a 12-month return of -60% never materializes. Sunny weather in Zurich and barf bags while flying over Iceland!
To gauge the impact of how badly our portfolio might get dinged by just one month of stock market volatility, let’s look at the following thought experiment: Starting with the option above with a price of $11.50 on April 30, 2021, I calculate hypothetical option prices for May 31, 2021, after applying a variety of monthly stock returns and monthly changes in the VIX. Instead of using completely hypothetical SPX and VIX changes, I use the historical monthly changes observed since 1990. So, for example, in March 2020, the S&P 500 price index dropped by 12.5%, while the VIX increased by about one-third (+33.5%). What if that same blowup happened again in May 2021? Let’s take a look. In the calculations below, I reprice the option as of 5/31/2021 after dropping the SPX to 3,658 and scaling up the IV by a factor of 1.335. The option price would shoot up to $65.12 for a total loss of $5,362. More than the initial margin and even with $15,000 in your account initially, you would have lost 36% of the account after a 12% drop in the index. So much for a risk-free investment: your short option account would have lost three times as much as the index!
Side note: This calculation relies on the assumption that a shift in the VIX would scale up the entire Vol curve proportionately. I don’t have the historical quotes to prove that, but my personal experience certainly supports the idea that the vol smile/smirk certainly stays intact and might even be exacerbated during financial stress periods. Maybe my blogging buddy spintwig can take a shot at simulating this with historical options quotes?!
OK, so this was one single month, how about all the other monthly SPX and VIX changes since 1990? Let’s plot that in the chart below. Historically, the worst monthly P&L would have been a loss of almost $28k in 2015. That wasn’t even during a bear market. The surprise Chinese Yuan devaluation came out of “left field” and sent the stock market tumbling (-6% for the month) and the VIX more than doubled in one month. But other stock market crashes would have also caused some nasty losses. Quite intriguingly, out of the six losses worse than $10,000, only 3 occurred during a recession/bear market, the rest were simply short corrections:
- August 1998: Russia Crisis, LTCM (no recession, no Bear Market)
- Both September and October 2008: Global Financial Crisis (recession+bear market)
- August 2015: Chinese Devaluation (no recession, no Bear Market)
- October 2018: Q4 scare, growth concerns, monetary policy uncertainty (no recession, no Bear Market)
- February 2020: Global Health Crisis (recession+bear market).
Also, 40% of the monthly SPX and VIX changes would have caused losses in the short put position. About the same “hit rate” as a plain-vanilla equity index fund!
Problem 4: It looks even worse when using intra-month data!
Note that the worst monthly drop during the 2020 bear market came not from the dramatic decline in March but the prior month. March 2020 was “only” the 17th-worst month when measured by the short put option P&L. Does that mean we didn’t have to worry too much about the crazy market moves in March that year? Not exactly. The bottom of the bear market was on March 23, 2020, and the market subsequently recovered quite nicely in the last few days. The S&P 500 recovered 15.5% by 3/31 and the VIX also declined quite noticeably.
But if I were to feed in the 31-day move between February 21, 2020, and March 23, 2020, with a 33% drop in the S&P and a 261% increase in the VIX, the numbers would look much worse. With implied volatility all the way at 153%, the P&L from the option would have been, wait for it, -$77,167. This would have wiped out your $15,000 more than five times over. How crazy is an IV of 150%? Not that crazy. During the volatile weeks of March 2020, I routinely traded my short puts with implied vol numbers between 120 and 150%. The VIX index exceeded 80 during the month of March, and due to the volatility skew, it’s certainly realistic that a way-out-of-the-money put option will easily have an IV twice the value of the VIX. For example, on 4/30/2021, the 1700-put had an IV of 42.62% when the VIX was at 18.61!
The same criticism applies to many of the options strategies marketed to unsuspecting investors!
The option gurus that want to sell you courses on how to make 30%+ annualized returns make the same mistakes:
- They exaggerate the expected returns by using the minimum margin requirement in the denominator. No serious options trader would ever calculate the expected returns this way! If you see anybody calculate the expected return this way, and most option gurus on youtube do this to market their 30% or 60% return claims, you should not walk, but run away as fast as you can. These guys have more experience in selling courses than trading derivatives. To hedge against even moderate market moves you need to have a margin cushion much larger than the initial/maintenance margins. And longer-dated options have a lot of Gamma and Vega risk!
- They exaggerate the expected returns by using the gross option revenue in the numerator without accounting for losses along the way. In my personal experience trading my strategy for about 10 years now, I’ve sold options with a combined premium of over $1,000,000, but I also paid out around $370,000 when my short puts ended up “in the money.” I currently have a 63.9% “hit ratio.” But to be on the conservative side, I budget a 40% hit rate just to be on the safe side in case I was just plain lucky during the last 10 years.
- They ignore the delta/gamma/vega risk along the way and only show you where the underlying has to land on the expiration date. That might look like a safe bet, but ignores all the things that can go wrong in between – think of the barf bags in the airplane!
Similar mistakes also resulted in the optionsellers.com meltdown and the UBS Yield Enhancement Strategy losses. For example, most of the Nat Gas call options that optionsellers.com shorted indeed expired worthless in the end. They would have made a ton of money in February and March 2019 if they hadn’t suffered catastrophic losses in November 2018, causing a total loss of all customer accounts, plus additional losses, with the clients holding the (barf) bag!
My personal options trading involves ultra-short-term put writing with a little bit of leverage. I target around $140,000 in margin cash for every short put option. As I detailed in previous posts, the rationale is the Central Limit Theorem from basic math/statistics: By averaging my investments over 150+ (mostly) independent bets every year, I can generate relatively stable income without too much downside skewness. This suits my retirement cash flow needs perfectly. Even though I need to sell with strikes much closer to the current index level and I suffer occasional losses I view this as the safer strategy. The market can melt down much worse over a 1-month period than over a 2-day period. The return profile of the 1-year-out short-put option I studied above is actually so horrendous over the first month of the contract, it looks more like a candidate for a cheap hedge, i.e., go long that put to insure against a “black swan” event.
If you want to employ one of the strategies involving short put options with a long time to expiration, make sure you don’t put all eggs into one basket. Maybe stagger the contracts so that you sell a put every month using only 1/12 of your money. But a back-to-back meltdown like September/October 2008 or February/March 2020 could still wipe out your portfolio. Another idea would be to use credit spreads (vertical spreads), so you hedge the downside by going long a put with an even lower strike. But that eats into your already-low profits.
Sorry if I unloaded on that poor guy who left those comments last week. I want to end this post on a consolatory note and wish him good luck, though. If Miguel’s portfolio doesn’t blow up soon we will all have a smooth ride going forward! Cheers to that! 😉
Hope you enjoyed today’s post! Looking forward to your comments and suggestions!
Other posts in 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!
Title Picture Credit: pixabay.com