January 9, 2023
Happy New Year, everyone! I haven’t written any updates on my put-writing strategy in a while, so I thought this is an excellent opportunity to review the year 2022 performance and some of the changes I have made since my last write-up in late 2021.
Let’s take a look…
After three blockbuster years in a row, 2019-2021, I knew this sort of largesse would not last forever. But here’s the good news: I still made money from selling put options in 2022, just not as much as in previous years. Some losses along the way pushed down the premium capture rate (PCR), i.e., the share of the gross option premium I keep as profit. Making money selling downside insurance on the index is still an achievement, considering the S&P went through a Bear Market in 2022.
More disappointing, though, was the meltdown of the underlying bond portfolio. Again, if you’re unfamiliar with my options approach, you start with an existing portfolio that serves as collateral for the put trading on margin. You can use any stock, bond, ETF, or mutual fund portfolio. Currently, my Interactive Brokers account exclusively holds fixed-income assets. Then trade the put options on top of the existing portfolio to generate additional income.
The net-net: My total account was down by 11.6%. Without the options trading, I would have lost about 16%, so the options added about 4.7% return. That 16% loss for the fixed-income portfolio is roughly what you’d expect, considering that all major asset classes were down by double digits that year: stocks, Treasury bonds, Corporate bonds, and preferred shares; see the chart below. So, the options trading made the loss slightly less painful. But it cannot save you when the overall market is so uncooperative. Better luck in 2023. So far, it’s looking promising, +3.22% during the first week of 2023.
Here are a few more observations from the CY 2022 return chart:
- The long-duration Treasury bonds (20+ years to maturity), normally considered a great diversifying asset, got hit the hardest: -32%!
- Small-cap stocks did very poorly in 2022. That can explain why the total stock market funds (VTI, VTSAX, etc.) underperformed your US-large stock index funds (e.g., SPY, replicating the S&P 500 index).
- Small-Cap Value did not outperform much. Value helped because mainly the growth stocks got hit in 2022, but the small-cap bias almost completely reversed the advantage from the value tilt. Large-Cap Value would have been the best choice last year!
- International stocks did slightly better than U.S. stocks. But they didn’t offer much diversification either. If the market is down in the U.S., brace for impact anywhere in the world, as I warned in “How useful is international diversification?” a few years ago.
- You would think that going through a bear market, you will benefit from a long-VIX strategy (e.g., the VXX ETF). Not so this time. You lost 25%, even more than in the stock market. There is a constant drag on the performance due to the contango in the VIX futures term structure!
- Think that a dividend tilt will help you in a downturn? Indeed that worked in 2022 when looking at the Vanguard dividend ETF (VYM), down only 2%. But make no mistake, that’s not really because of the higher dividend yield. SPY has a 1.5% yield and VYM 2.8%. That 1.3 percentage point difference does not explain the 18 percentage point return differential. The sector and value bias in the VYM does! Notice that REITs have an even higher dividend yield (VNQ at 3.5%) but still declined 27% in 2022!
- What on earth happened to TIPS? Shouldn’t they protect you from an inflation shock? Sure, but if real interest rates go up, you still have a duration effect. For example, 10-year TIPS had a -1.04% (real) yield at the end of 2021, but that yield went up to +1.58% by the end of 2022 (Source: FRED). Sure, you got the inflation compensation (just under 10% for the CY 2022), but you also lost about 25 percentage points when the yield on your bonds with a duration of about 10 went up by 262bps. You can avoid that duration risk by purchasing I bonds, but there are restrictions on how much you can buy. Moreover, the I Bond yield is currently much lower, and if the duration effect ever goes in the opposite direction, you’ll miss out on the gains if you use TIPS. There’s no free lunch!
So, given that almost nothing worked in 2022, I consider myself blessed with my put-writing performance!
Put-writing return details
In the chart below is the cumulative return in my put-writing strategy. It’s a tale of two halves. The first half of 2022 was awful, with multiple large losses and essentially zero returns. The second half saw a nice recovery, though:
What happened here? Well, right out of the gate in the first week of January 2022, I had large losses both on January 5 and January 7. Then I got a really strong recovery until late April, only to lose it all in a single day on April 22.
That April 22 event deserves a closer look. That was back when we didn’t have the Thursday expirations. I sold my contracts on Wednesday, 4/20, expiring on Friday, 4/22, with strikes about 2.8%-3.8% out of the money. It looked like a good idea at the time and totally safe! But Thursday and Friday saw two back-to-back declines (1.48% and 2.77%, respectively), and all my strikes landed in the money, between 18 and 63 points! That hurt! Especially because I could have still cut my losses and gotten out earlier that day before the losses really piled up. This experience taught me to tread more carefully and make some changes to the strategy, including stop-loss orders; see below for more details.
In the remainder of the post, let me go through some of the changes I’ve made since my last post on the topic:
1: Going from 3 to 5 expirations weekly
The big news last year: the CBOE finally introduced options with a Tuesday and Thursday expiration in May 2022. We can now trade every single market day with a one-day-to-expiration (1DTE) short put. On Fridays, of course, I trade the 3DTE options expiring on Monday, which is still only one trading day to expiration.
The additional expiration days were welcome news! If you remember my other posts, I like to utilize the Central Limit Theorem to generate as many independent bets as possible. See Part 3 of the series and the related post “We are so Skewed,” detailing how the Central Limit Theorem helps you make the unappetizing, negatively-skewed payoff distribution of a naked short put look more like a Gaussian Normal distribution if you average over sufficiently many independent trials. Going from about 150 to about 250 annual expirations helps that effort. (side note: you also get twelve additional expirations from the SPX contracts expiring on the 3rd Friday of the month!)
Of course, five trades vs. three trades per week will use up a bit more of my time, but I trade the next-day expiration puts right around the market close, and I don’t have to spend more than 10-15 minutes on that. So, going from three to five expirations per week doesn’t really tax me too much. So, this would be another change in my approach: I no longer roll my contracts throughout the day but rather use same-day 0DTE contracts; see item 3 below.
And my performance certainly improved once I started the 1DTE options. The premium capture rate was 77% in the second half because I could avoid big disasters like April 22. Over one day, a lot less can go wrong than over two days!
2: Use more contracts, but target a smaller premium per contract
After the beating in April, May, and June, I realized I was a bit too aggressive with my premium target. Sure, it’s nice to make about $750 per trading day, but if the losses wipe out several months’ worth of gains, then it’s time to tread more cautiously. So, I decided to lower the premium target per contract, which pushed my strikes further out of the money. But I also trade a few more contracts daily to make up for some, but not all, lost revenue.
Do I feel nervous about trading more contracts and thus more leverage? Even with the additional contracts, I keep about $110k in margin per short put. Considering that the initial margin required for most of my short puts is around $35-37k, I hold about 3x the required minimum funds to run this strategy. That’s a really generous cushion. I don’t expect the index to fall by over 1,000+ points in one single day, and certainly not 1,100 points below the strike!
On most days, I try to get around $0.30-$0.45 of premium per contract, but I’m happy to go as low as $0.25 if implied volatility is really low. And sometimes, after a big drop and a vol spike, I will make back the lost revenue and sell puts with a $1.00 premium or even more. Assuming an average of around $0.40 leaves me only about 12x($40-$1.19)=$466 per trading day in gross income. A little bit less than the $500 I had targeted previously, but I will describe some ideas for generating additional revenue. This brings me to the next item…
3: Regular 0DTE (same-day) trading
The beauty of trading daily is that most of the time, the options I sold on the previous day have made 90+% of the profit overnight. Even if the market slightly drops at the open, you’ll often see a profit solely due to the theta effect. So, if at market open most of my contracts expiring that day are at a 0.10 premium or less, I’m comfortable issuing a few additional contracts expiring that same day. The calculus here is that I’m in the insurance business. If the option Delta of the existing contracts is essentially zero, then I’m not insuring enough and not making enough money.
Most of the time, I would supplement my twelve overnight contracts with six more 0DTE contracts with a premium of only around $0.15-0.20 per contract. Assuming $15 of income, net of $1.19 commission, we’re at $82.86 per trading day.
But I also ventured in the other direction, i.e., longer-term contracts. This brings me to the next idea. I explored ways of implementing longer-term options…
4: Longer-DTE contracts: 1-1-1 trades
As the name suggests, three options are involved, one long and two short contracts. The trade would involve puts, all with the same 30-60 days to expiration. One deep-in-the-money naked short put and a long bear spread at higher strikes.
Here would be one example trade: On 8/29, while the index stood at 4,135 points, I sold a naked put with a 3200 strike and a 3500/3550 bear spread, i.e., a long put at 3550 and a short put at 3500. The income for the naked put was $990, and the cost for the bear spread was $405. The rationale is that the long bear spread partially hedges against a deep drop in the index. In fact, if the index falls “only” below the bear spread strikes but stays above the lowest of the three strikes, you get to keep the naked short put premium and make the $5,000 income from the bear spread. See the P&L Diagram below. Sweet! So, this bear spread helps with some of the heartaches when the market goes against you. But make no mistake, the overall Delta of this option combination is still positive at the inception, meaning you lose money if the market drops soon after writing those contracts. About halfway toward the expiration, you indeed see a flattering of the P&L curve (assuming constant Implied Vol), and only getting close to the expiration do you see the nice bump in the P&L curve in that intermediate range.
Throughout the year, I made a total of just under $10,700 with 20 such trades. Also, this profit is not included in the above P&L Put Writing calculations and time series (so the total profit from my puts selling was closer to $73k). I don’t see the 1-1-1 approach as a good permanent addition to my trading program. The two main reasons: First, it was a wild ride! Having multiple short puts, even far out of the money, and even when they are staggered over multiple expiration dates, adds too much volatility and too much equity market beta. This is an issue I described in the post a while ago in Part 7 “Careful when shorting long-dated options!”; the trade seems safe, but the gamma and vega effects can really smash your portfolio if you suffer a deep enough drop early in the trade. And sure enough, this strategy had some major volatility from April to June.
Second, despite the bear spread, you still have a naked short put with a very expensive margin requirement. I don’t like to lock up that much margin on this supplemental trade. I noticed that occasionally I didn’t have enough margin to make all my 0DTE trades and roll my regular puts before market close.
So, considering that this trade with three 1-1-1 trades at a time (staggered at different expiration dates) ate up about 0.25x the margin of my regular trades (12 short puts) but made only about 0.16x the annual profit of my other trades, I paused the 1-1-1 trades for now. But I might revive them again if I feel like it. Maybe I should pick up a few generously priced puts after the next market meltdown. If anyone has experience with this trade, feel free to share it in the comments section or the forum.
5: Stop loss orders
My approach evolved in another meaningful way: I’ve been using stop-loss orders since the second half of 2022. Of course, in 2022, I still got it all wrong. Before using the STP trades in the first half, I had a significant drawdown when the market broke through my strikes. In the second half, I had several false positives where the STP order went through, and the market eventually recovered (Sep 23 and Dec 22). Murphy’s Law, I know, but in the long-term, it’s prudent to limit the downside just a little bit. It takes too long to recover if you suffer a loss worth 50+ points in the money. I’d rather have a few false alarms where I get stopped with a four or five-point loss ($400-$500 loss per contract).
The stop-loss order was something I scoffed at in earlier posts, but it’s something I will now use regularly. Especially chatting with David Sun from the Trade Busters podcast convinced me this is the right thing to do. Talking about his podcast, make sure you stop by and listen to Episode 73, where he describes his take on the ERN Put Strategy. And Episode 74, where he interviews me.
6: Shifting out of Muni Bonds and into Preferred Shares, with mostly floating-rates
In my post from 2021, I wrote about my Muni Bond Closed-End Fund (CEF) holdings (e.g., NZF, NMZ, NVG). I cut my losses and moved to floating-rate preferred shares in June 2022. In hindsight, it was a good move because those funds performed worse than the preferreds in the second half of 2022. But by mid-year, the Muni bonds had already lost a ton of money, so I couldn’t escape the losses that almost all fixed-income assets endured in 2022.
I like the preferred shares even if the dividends are taxable. The yields are currently attractive, especially shares that are already floating or are close to switching from fixed to floating had relatively little interest rate risk. For example, the “C PRN” price went up in 2022. And it also pays a 10% yield!
In the table below is my Preferred Watchlist. Notice that the selection of shares with already floating rates is limited. Most of the shares are still in their fixed-rate state but will eventually go to floating within the next few years. I’ve picked up a lot of the shares with a relatively low LIBOR spread but with a 3.5-4.0% floor. They trade at a very generous discount ($19-$20) relative to the $25 notional value, so the yield is currently around 7%!
Update 1/14/2023: Readers below asked for my view on the PFFV ETF, which invests in variable-rate Preferred Shares, and also some guidance on what exact Preferred Shares to invest in.
My views on the PFFV ETF:
I considered it. But I think I can do better: First, I can save the expense ratio (0.25%) by DIY. Second, I can do more efficient tax-loss harvesting by holding the underlying assets. Also, the bid/ask spreads are indeed tighter in the PFFV, but some very liquid PS come very close (e.g., C PRN). So, for a long-term buy-and-hold strategy, spending a bit more on the B/A spread is worthwhile. You will make that small spread back in less than a year!
Considerations when picking Preferred Shares:
- Interest vs. (qualified) Dividends: you face a higher tax rate on the interest. But you often get higher rates for the interest-paying ones, e.g., C PRN (interest) vs. C PRJ (dividend).
- Quality vs. “junk”: You get lower rates for A+ names like C, GS, MS, STT, and WFC. Higher rates for exotic REIT PS like NLY. Don’t invest too much in junk names! They are very volatile! Goldman Sachs will survive the next financial crisis. A mortgage REIT may not!
- Already Floating vs. soon-to-be floating: Depends on how long you think the high interest rates will last.
- Above vs. below par. I wouldn’t stress too much about that. Efficient markets price that in. Sometimes you get higher dividends, but you pay above par. Sometimes you get lower rates in exchange for buying well below par. But I took a liking to the shares like GS PRA/PRC/PRD. Deeply discounted below par but also had a very small LIBOR spread.
7: Using Leverage in the bond portfolio
I don’t sugar-coat anything: my combined preferred share portfolio still went down last year. But many of the preferreds suddenly looked very attractive at those low prices and high yields in the second half of 2022. So, I went on a “debt-fueled shopping spree” to pick up some bargains. I used the technique I described in late 2021, the box spread trade, which allows me to generate a margin loan out of an options position at an almost unbeatable interest rate, usually only about 0.20 to 0.30 percentage points annually above the corresponding Treasury yield. Moreover, the loan cost is not debited as interest but rather a Section 1256 index derivates trading loss. Thus, your loan “interest” is tax deductible because it comes in the form of 60% long-term and 40% short-term capital losses. Sweet! I can net the cost of the box spread loan against my options trading gains! And most of my dividend income is in the “qualified dividend” category with a 0% rate (up to $110,000 for married couples) and 15% beyond that.
Currently, I borrow an additional $64 for every $100 in equity I have in my portfolio. The average after-tax interest rate on that loan is only slightly above 3%, factoring in a combined 17.8% tax rate = 0.6×15% long-term cap gains rate plus 0.4×22% short-term cap gains rate. With many of the preferreds yielding 7% and some above 10%, it seems justified to use a little bit of leverage. I will keep you posted on how that works out in 2023!
So much for today. Please share your thoughts in the comments section below! I’d be interested in reading about your 2022 put-writing stories!
Title Picture Credit: pixabay.com
100 thoughts on “Passive income through option writing: Part 10 – Year 2022 Review”
Happy New Year Karsten!
Thank you for sharing your strategy and being honest with the results!
Big kudos to you and your strategy for the year. I am impressed by your returns considering the global performance. Although, our portfolio is simpler with a few large accumulating ETFs, I will review all your posts about option writing to understand the risks before trying.
Thanks again and best wishes for the New Year to all the ERN community!
Thanks! Yes, please check out the other posts before putting any real money into this. It’s suitable for experienced traders only! 🙂
Happy New Year to you too!
Loved the article ERN. Looking forward to when we meet again. Since we last spoke, I’ve dove deep into options and have some interesting metrics to share. Hit me up if you have time to chat.
Thanks. Feel free to share.
I had similar performance – down about 13.4% on my bonds, up 10.9% on SPX puts. I had losses on most of the same dates as you but of different magnitudes. I was selling <=5 delta puts for $1-$1.2 when the daily options became available, slightly more money per put when it was still 3 expirations per week. I started the year using 4x notional leverage and gradually adjusted down to 2x notional leverage as I approached retirement near the end of the year. My biggest loss was also in April but twice as big as yours in dollar terms, but my loss the first week of the year was minimal. I still ended up back at 0 in April. I sold those April puts immediately before the market started dropping intraday, so the worst possible timing. I started sitting out days before CPI reports and Fed press conferences, but it was something of a mixed bag on how much that actually helped me. I also started buying SPX box spreads instead of buying T bills towards the end of the year. The income from them being treated as capital gains was much more tax advantageous for me compared to interest income from T bills.
YMMV and I’m not a tax accountant, but long box spreads read to me like a conversion transaction which means they would be ordinary income per section 1258. The value to the investor is based substantially on the passage of time, which taking sections a and c together suggests it should be recharacterized as ordinary income. https://www.law.cornell.edu/uscode/text/26/1258
John, I’d welcome comments from you or from anyone out there as this is certainly outside of my area of expertise. Selfishly, I’d also love to be shown that my interpretation is wrong to take advantage of 60/40 treatment myself.
I had not heard of this, so thanks for the tip. I can’t find any other information on this or anyone’s experience with it or interpretation of it. This is my first year trading box spreads, so I’ll see if things turn out any different than I thought they would.
It seems most blogs and forums say it’s 60/40 but it feels to me like that just because the broker gives you a 1099 that doesn’t consider this issue. I think I learned about the potential for this deep in a bogleheads thread but it seems I failed to bookmark that when I researched this.
If my interpretation above is right, it suggests a manual adjustment on taxes would be required (though unlikely to be noticed unless you’re audited). There are a couple of other such adjustments that come up sometimes. For example, the minimum six month holding period for tax free income from muni bond ETFs – which I was made aware of from ERN’s forum here. But again, I’m no accounting expert so please consider this awareness raising and not advice!
I think all the people saying it’s 60/40 are only talking about things other than box spreads (and as far as I know that’s correct – I’ve never had any problem with filing my taxes that way anyway). Also most people trading box spreads in the last few years have been selling them to get loans at low rates, not buying them, so that would show up as a loss instead of a gain. That probably explains the lack of discussion.
Not true. Net profits/losses are reported as S.1256. In fact, being able to write off the interest expense as ordinary income loss would help me, but that’s not how it’s reported on your tax forms.
Thanks for the update, I have used your strategy and appreciate your sharing your knowledge!
One thing to note on the tax reporting from brokers. Just because they report it one way doesn’t meant that’s how the taxpayer should report it. Note this doesn’t mean that the broker is doing it incorrectly, just that sometimes they may not have the information and/or aren’t required to provide it to the IRS. E.g., at my old firm wash sales were reported if the purchase was in the same account and was the identical CUSIP but not in other cases where the firm knew there to be a wash sale i.e., a purchase in another account belonging to the same person. Also dividends reported by a fund as qualified were reported as qualified even if the holding period had not been met – in theory the taxpayer could have met the holding period at a different firm.
The OCC’s education page says you have the “potential” for section 1256 treatment but IMHO a plain reading of 1258 says taxpayers should recharacterize a gain (but not a loss) on a box spread as ordinary income. Having said that I don’t plan on doing any box-spread “lending” and if I did I doubt even most auditors would question it if I used 1256 (but definitely not tax advice).
Agree. But again, this doesn’t impact me since I’m only borrowing with box spreads.
For people who are lending via box spreads: I’m not a tax expert. But this seems to be a safe place where a) it’s unlikely the IRS will ever find such trades (because on Form 6781, you only report net trades) and b) if you’re caught, you can pretty safely claim ignorance. 🙂
Thanks for sharing! Yeah, I thought about sitting out certain days, but the IV seems very rich around the very risky days. The market seems pretty efficient that way.
Also, it’s great to see that people also find use for the box trades in the opposite direction. Save the expense ratio for a Treasury bond fund and enjoy the better tax treatment as well!
I do not understand the decision to risk up. It is pure opportunistic? There is still a lot of excess liquidity and so significant risk of a comeback of inflation and further rising interest rates.
True. But again, most of the preferred shares are now close (or at least closer) to their floating date. I’m willing to take that risk with 4-5% of positive carry. Time will tell.
I’m dabbing into PS for first time.
What do you call positive carry? Yield % over the Libor after they float?
Do you have any advice how to select PS? Buy only below liquidation value, only non recallable etc?
Any advice welcome 🙂
Positive carry = Dividend on PS > interest on the loan. Both sides in after-tax interest rates.
I posted the table with my holdings, even my % allocation.
The major decisions:
1: Interest vs. (qualified) Dividends: you face a higher tax rate on the interest. But often you also get higher rates for the interest-paying ones.
2: Quality vs. “junk”: You get lower rates for prime A+ names like C, GS, MS, STT, and WFC. Higher rates for exotic REIT PS like NLY. Don’t invest too much in the junk names! They are very volatile!
3: Already Floating vs. soon-to-be floating: Depends on how long you think the high interest rates will last.
4: Above vs. below par. I wouldn’t stress too much about that. Efficient markets price that in. Sometimes you get higher dividends, but you pay above par. Sometimes you get lower rates in exchange for buying well below par. But I took a liking in the shares like GS PRA/PRC/PRD. Deeply discounted below par but also had a very small LIBOR spread.
Thank you for the update!
I have been using a new strategy I came up with which I use on various time frames from O DTE to 45 DTE. You essentially sell a 70 Delta Put (ITM) and use the extrinsic value (corresponding value of the Call at that same strike) from that put sale to then buy a put OTM for whatever you can get with that amount of extrinsic value. You then sell the ATM Call strike and buy an OTM Call at around the 10 Delta or so. You are in essence selling an ITM Iron Condor of sorts that acts like selling an ATM Covered Call, but margin used is very minimal as a result. It usually comes out to around a 2 to 1 reward to risk. Can use either SPX or XSP so you avoid any assignment risk.
Interesting. I don’t really like ATM covered calls because they still have a lot of Delta/equity beta. How much net delta do you normally have?
It is normally almost Delta neutral when initiated due to the long put leg that is normally not part of a covered call position. I like this aspect knowing my downside is very limited, and the sleep well at night factor.
Hi BigERN, thanks for the update on this series! This series has been really interesting to see how your analysis and thinking changes over time. Can you clarify what your latest thoughts are on when to open new contracts? On Monday morning, you will have some existing contracts that you opened on Friday. From the latest update, it looks like you might open some more Monday expirations if your existing position delta is very small. I assume you do that right away and/or throughout the day on Monday? When do you open your new Tuesday expirations? From the above, I’m assuming that you open your Tuesday contracts at the end of the day on Monday (e.g. 15 min before close?), but in the past you’ve mentioned that you might open the Tuesday contracts as early as Monday morning, if your delta is low. Do you have any new thoughts on when to open new contracts? Also, above you talk about rolling, but you are letting contracts actually expire, not closing any contracts early (except for your new stop losses), right?
My approach here has evolved. I used to sell the Wednesday options on Monday morning if the Monday options were far enough depreciated. (back in the old days with M/W/F expirations)
But I had a few accidents where the market went down on that day and was followed with more losses the next few days.
So, to deal with low delta in the exiting positions, I only sell 0DTE for the same day. Normally during the morning. But sometimes I still grab some good deals 30-90 minutes before expiration.
Then the options for the next expiration day are all sold 10-15 before close to about 5 minutes after close. Note that the SPX options trading stays open until 4:15pm Eastern Time!
Wow I did not know you could sell SPX options until 4:15pm – this would be ideal so you dont have a small window of time where you are technically holding twice as many options (and requiring twice as much margin). Are the bid/ask spreads still pretty good during that 15 minutes?
You must wait 20-60 seconds after closing for your margin to be released. But then you got your entire available margin cash back, and you can trade at average B/A spreads. I’m usually done with my trades by 4:02 pm if I have to trade after the close.
Appreciate the update! Your series inspired me to trade SPX. I’m using a variation of your strategy that is more active, but curious for your thoughts. Thank you 🙂
Since Nov, I started opening SPX Short Put Spreads for 3/5/7 DTE, at Delta 5. I select my DTE based on VIX and support/resistance zones of SPX. If VIX is low, or we are near a resistance zone, I like to keep DTE to 3. I aim to open contracts on Mon for Fri expiration, or open on Wed-Friday for the next M/W/F. This means mid-week, I may have overlapping contracts, e.g. Mon-Fri open contracts, but I see an opportunity to open new set of contracts on Wed-Mon or Wed to next Fri. I’ve found this helps me spread out my risk better with average of 5 DTE and enter them usually on M-W-F.
To manage, I start with strike width of 25 or 50, per contract ($2500, $5000 collateral). I found that this helps me manage margin risk better and my ability to roll. To roll on expiration, I will widen my initial 25/50 wide strike to 50, 75, 100 max ($5000,$7500,$10000) to capture more premium on the roll, so that I can roll down and out for shorter periods like another DTE 3-7. (Otherwise, if I had it naked and rolled out for 30 DTE, vega/gamma could keep moving against me hard). So I’m counting on widening strikes to allow me to roll to shorter DTE for expiration OTM.
Closing, I typically close at +70% profit. I will close earlier at 30-50% profit if we had a very strong move up, or we hit an expected SPX resistance zone.
That’s an interesting variation! So, the spread has a net Delta of 5?
Also, do you use stops on this one? With a big enough move you might take out all overlapping spreads.
But generally, yes, this looks like a cool variation of my strategy. Hey, we can’t all run exactly my strategy, because that would get too crowded, right! 🙂
The spread short put is at Delta 5. The long put will be 50 wide strike, about Delta 2. Net Delta is 3.
I don’t use stops. I just ensure that any needed net roll, collects more premium (either first by widening my strikes on the roll, and/or more time). The reason I moved away from stops was my experience with 0DTE, Iron Condor strategy on SPX. With the vol of this market, I got stopped out too quickly, only for it to immediately mean revert.
Yea with a big move I might get wrecked just the same on my 3 different entry overlaps. As a rule, I will avoid holding positions going into binary event days like CPI, FOMC, Bank earnings, Big Tech earnings.
Thanks for the the input BigERN!
Hey Karsten, thanks for the update! Put options are well outside my zone of comfort, interesting to read what you’re doing with them.
Something I noticed at the end of your post, you say “most of my dividend income is in the “qualified dividend” category with a 0% rate (up to $110,000 for married couples) and 15% beyond that.”
But I was under the impression that qualified dividends were taxed like LT cap gains, which have a 0% rate up to $83,350 for married filing jointly in 2022. Am I missing something?
$83k plus the $27,700 standard deduction. That makes the first ~110k tax free,
Now we know why all the puts get wrecked into the close – Big ERN comes and sells all the vol (:
Will try to front run you now.
Haha! But there’s a grain of truth: we shouldn’t all be doing the same trades at the same time with the same Delta. Let’s spread out the strategies! There’s room for everyone!
I completely agree, which leads me to the question: why aren’t you selling vol in other spaces? I’m doing gold futures options, and it seems to work (got the Spintwig approval too).
Good stuff! What is your system for determining where to set your stop loss? Is it always the same, or does it vary?
For same-day trades, I’d pick a STP at about $1.00-$1.50. For overnight trades at around $4.00-6.00.
I’d presume you feel even more comfortable running a healthy amount of leverage now that you have some stop protection. It’s not ‘defined risk’ per se but the slippage shouldn’t be too bad except for gap downs on the open. Easier to run 3.5-4x leverage when typical loss probably in the $500 range vs larger.
Question: when you get stopped out, do write another 1DTE or 0DTE immediately? or do you let it breathe and do your normal end of day entry?
Comment: to whatever extent you would still use ETFs for your bond side, you could also park a stop order or a trailing stop for those as well at say the 200 DMA or an arbitrary ‘breakdown level’ per the chart. Ex) for MUB, could have been in the $114-$115 range and saved a ton of headache and losses. Small risk of a whipsaw but you’re not trying to protect against every downdraft, just big shocks
That’s a lesson I learned this year in managing my collateral against the Naked Puts in the 2020 shock.
If I get stopped out during the day I would normally sell another put at a lower strike with that same expiration. To make at least some of the money back.
I used the PFF ETF but noticed that the expense ratio is way too high. I’m now using the individual preferred shares, as specified here and in earlier parts.
Thanks for sharing those details! I had assumed your put selling strategy was pennies in front of the steamroller, but it appears you’ve made money even in a year when the steamroller came. I’m impressed.
1) I suspect you’ve invested some time in automating data flows so that you could produce these performance charts and graphs without spending hours per week logging trade details. How did you do it? Some kind of broker report to Excel tables macro? Automated links to Google finance?
2) Would 0DTE bull spreads offer a higher ROI, lower margin/risk, and reduced damage from losses than ODTE naked puts? Or would the smaller yields push you into riskier deltas?
1: I enter my daily P&L into an Excel sheet. No automation.
2: I don’t like bull spreads for 0DTE so much. I usually set the STP at $1.00-1.50. With a Bull Spread, you’d need 20-25 pts spread at least. And then occasionally suffer a $25 loss when you make only $0.15-0.20 per trade? Seems unattractive to me.
But I’ve been playing with the idea of buying some cheap OTM puts for $0.05 per trading day to hedge the extreme downside. But only for the overnight trades, to hedge the risk of something happening between close and open when the STP orders don’t work.
Hi ERN thanks for sharing your progress. I followed your blog first back around early 2021 and was curious. I don’t exclusively sell puts, but it is one of my strategies. I also do own shares from time to time.
One thing that I have done early on is using some form of a stop loss. Whether it is 2 weeks worth of premium or something. Having open ended losses without and form of risk management and having a large drawdown wasn’t worth it to me. I took one trade that was I believe a 3-4 week draw down and after that I now use pretty routine stop loss risk management. Even if it is a false trigger, I know at least where the loss puts for so I can get back in the next day. I also do that with equities I hold as well, so I did take stop losses last year and my overall return wasn’t as bad as most were b/c of it.
Thanks again for the info.
Thanks for sharing. Exactly my thinking! I’m glad we’re on the same page with the STP orders.
Interesting and well written as always, thanks Karsten!
One question regarding preferreds – why not PFFV?
If it’s the .25% ER, what ER would you switch to an ETF strategy over manually buying?
I considered it. But I think I can do better:
1: save the 0.25% e.r. by DIY
2: do more efficient tax-loss harvesting by holding the underlying assets
And the bid/ask spreads are indeed tighter in the PFFV, but some of the very liquid PS come very close (e.g., C PRN)
So, for a large enough account with seven figures in PS, I “prefer” (pardon the pun) to do my own allocation.
Selling SPX puts has been my only consistent winner in the last year. I accidentally missed those large draw down days because I had surgery and simply forgot to trade. Better lucky than good!
I am so thankful that you continue to update your trading strategies for us readers. I used to scoff at stop loss orders too but you’ve convinced me. I will be incorporating that into my strategy.
Awesome! Thanks for sharing, Bob! Glad this added some alpha to your portfolio last year!
Some excellent info here.
You don’t know it, but you probably influenced my trading journey the most. The biggest concern I have with these 0,1 DTE puts is that any mini black swan event make rolling/stops almost impossible to execute before prices get way from you. So from this perspective, even though longer tenor option writing invites more risk since it has more time to fall, it makes rolling much easier and less stressful.
Overall, put writing is all about gap risk. Once you start writing far otm, (<15d), those gaps become hard to quantify because they are rare. but that's where the real risk of this strategy comes from.
I use a risk model to estimate how much the index has to fall close->open before I get above the STP limit. It’s a big gap. Unlikely.
And also recall that initially, I used no STPs and just let stuff expire ITM. Worked very well in 2020, including March 2020.
I’ve always been paranoid of a low IV, calm markets situation where markets suddenly gap down a few % due to some crazy geopolitical news like somebody is launching a nuke and although the 0 dte short puts may still be otm, the vega just destroys the position and I would be down huge without being able to react. Whereas if you were short longer tenor, you have a better chance to roll.
Am I right to think this way?
The longer duration puts would be hit even worse by the vega in that scenario than a 0 DTE. There is just so much theta at that point…
Agree. All else equal, longer DTE options will get hammered even worse. A lot more can go wrong over longer horizons! On the other hand, when vol builds up over time (2007-2009 GFC, 2020 pandemic) it’s much easier to walk down the strikes over time.
Completely agree. I had some of my best returns in March 2020 when everyone was scared and I could sell SPX with a 1700 strike.
But it’s scary when the market is really calm and you get only pennies for puts 2% OTM.
Thank you for updating this series. I’m sure you’ve mentioned it somewhere, but what is your expectation for annual profit per SPX contract?
Also, what peak to trough maximum expected drawdown do you budget for? When you experience drawdowns do you sell off some of your underlying shares since you’re using that for collateral instead of cash? If so, do you do that pro-rata across all holdings or some other way? Thank you.
I’m fine with a 12-15% loss in a once in 40 years event (like October 1987).
I assume you mean 12-15% drawdown on your total IB account attributable to the SPX puts? Spintwig’s part 9 backtest shows a maximum drawdown of only 3-5% for 2-3x leverage on 5 delta puts, but it seems prudent to budget for more than that considering the tail risk, so just curious how you think about it. Thank you.
Correct. Spintwig ‘s data wouldn’t go back far enough to capture some of the 1980s disasters (Oct. 1987!), so I budget a bit more.
But so far so good. I never had a day/day return even close to that.
I target about $5,000 per contract per year, net of all occasional losses. Though, 2019-2021 was far more profitable.
Whoa. I thought I knew a little bit about FIRE and investing but this felt like it was written in an entirely different language 😂
Have any resources or articles about entry level options stuff? I’ve just been vanilla index investing, hit FIRE last year and RE @30, not going to go risking the portfolio on options but interested to learn and maybe dip a toe
The stuff I write here *is* the entry level content. For advanced material, there’s the Whaley book with all the options math (https://www.amazon.com/gp/product/0471786322/ref=as_li_tl?ie=UTF8&camp=1789&creative=9325&creativeASIN=0471786322&linkCode=as2&tag=earlyretir007-20&linkId=d7648fb59b4ec09774e9acf87c32adb8)
You might also like David Sun’s Trade Busters podcast for some more entry-level treatment of this.:
(episodes 73 + 74 are on the “ERN puts”)
Hi Ern, thank you for this series, I’m exploring these strategies and was wondering why you stated in the UBS fail post that you would never touch an iron condor, but the positions in the spreadsheet linked in the podcast are iron condors basically? Or am I getting this wrong (strangle + long put/call wings).
Thank you for initiating my leaning process at first.
Looking forward to future posts
Personally, I’m only doing one leg: a naked short put. The Iron Condor requires four positions: short put and call OTM and hedges with long put call further out in the wings. I’m not proposing that.
I’d certainly not propose the Iron Condor for very long DTE because your Iron Condor goes away from zero Delta pretty quickly. But I can see how some 1DTE put shorter with a higher Delta hedge the downside with a long put in the wings, just to be sure.
Maybe they linked a wrong spreadsheet. With your link the podcast page says:
“Here is a Link to the ERN Strategy Spreadsheet. ”
It is basically showing Iron Condors. I had the expression it was your Spreadsheet since it contains a tradelog and a similar history for 2022 in a figure…
I guess he should have called it the ERN-style strategy because I’ve never used an Iron Condor.
Thanks so much for an update on your put writing strategy! My favorite kind of post! I’ve implemented your strategy for years now which has been a great learning experience. I also switched to 5 trades per week when daily expirations opened up.
I have kept my entire options trading portfolio in a single municipal bond ETF (MUB) to keep things simple and generate tax free dividends. However,
this[last] year [in March], I sold all my MUB after taking a $20k loss (about 4% drop) early in the year and just left it in cash till the end of the year. I got spooked by the constant rate hikes from the Fed. I made about 3% ($14K) on my SPX put options trades for the year which did not quite offset the losses from my muni fund.
However, I made about $50K last year by short selling VIX futures periodically every time the VIX spiked above 30. I generally would stick to futures contracts with a minimum of two months till expiration so I could ride out the entire VIX spike. I’m curious if you have ever incorporated any use of VIX futures contracts in your trading strategy.
Wow, that’s great timing. It took me until June to roll out of all my Munis.
Shorting VIX futures is something for the pros. I would consider the other side of your trade: going long VIX futures when the VIX is low. As a hedge against a crazy market event.
Shorting VIX futures seems risky, see my old post: https://earlyretirementnow.com/2017/10/25/returned-over-100-percent-year-to-date-still-not-buying-it/
But if you do it tactically and only when the market is oversold, maybe that’s the way to go.
Yes, short selling VIX futures is very risky! Like trying to catch a falling knife. But then again, my options trading strategy is like picking up nickles in front of a stream roller. And I haven’t even mentioned my foray into Bitcoin!
Haha, always good to see that some people are more adventurous that I would ever dare!
Correction: I sold my muni ETF not this year but last year (on 3/9/22 to be exact) due to sky rocketing inflation and the threat of Fed rate hikes.
Yeah, good point. I edited the other comment to reflect that. But it was obvious what you meant, haha! 🙂
Thanks for another update! I’ve been building a very similar portfolio (currently 60% preferred/baby bond, 30% equities, 10% CEFs) with an XSP 1 DTE option strategy similar to yours (SPX is too much leverage for my liking for my account size). I have also been picking up many of those preferred issues you listed (mostly banks/financials and a few mREITs and others sprinkled in). I’m surprised to see you are leveraging them up such a high amount… 64%! I did my first box spread for Dec ’26, but that puts me at only 5% leverage. Was thinking of going as high as 25% if we see credit spreads open up again, but impressed you have gone up to 64%. Are they all longer duration (like in your box spread post)? As long as you see a healthy spread between the yields on the preferreds and the box spread, do you plan to just roll those out as they approach maturity?
Well the duration is infinirte for most of them, but they can be called, usually after they go to Floating. If they get called I simply pay back the box spread of move to some other preferred share.
Thanks for discussing this passive income idea. Worth reading.
I’d have to go back and carefully read all your posts on the short options strategy to have a better grasp. But saw this headline and thought of you: “Marko Kolanovic Warns Of ‘Volmageddon 2.0’ From 0DTE Option Craze”
Is this strategy not that “niche,” anymore?
And how badly could it blow up in one’s face? IE buy S&P it drops a lot, you still own shares, presumably eventually recovers. Add leverage and derivatives things can get crazy?
Good question on this important topic.
It’s a concern. A lot of the 0DTE trading is due to potentially inexperienced traders taking huge bets. But here are a few thoughts:
I survived through Feb 5, 2018. I suffered a loss but it wasn’t my worst loss. The short VIX futures got hit much worse than the SPX itself. That day’s SPX loss was merely a pretty bad day in the stock market. If a 4% drop in the market threatens your portfolio you’re taking way too much risk. I currently use about $100-125k in principal per short put. I don’t see the SPX dropping by 1,000-1,250 below my strike in one single day. That said, the VIX doubled and anybody who had either short VIX or short long-dated puts got hammered that day (Vega effect). So, in many ways, I believe that 1DTE short puts are safer than the 45-90DTE short puts that some folks are using.
Also, I wouldn’t wait until the short puts got ITM. I currently have target losses That would make me clean out my positions way before I get to ATM or ITM. But in a flash crash, this would be a problem. So, yes, I’m aware of the problem but I think I have enough margin and enough cushion to survive that.
Also, some folks do vertical spreads, where the spread is calibrated to limit the loss to a certain % of your portfolio. That would hedge against any drop, even a 100% drop in one day.
Preferred broker to do 0DTE..? Anyone using Vanguard?
Not sure if Vanguard is a good broker for 0DTE SPX options or ES futures options. I use IB for options trading. Fidelity/Vanguard are pretty good only for ETFs and Mutual Funds, maybe single-name stocks.
Great in depth read. Just learning some of the ropes. Lot to consider here as there is going to be ups and downs, especially this next year or two. Appreciate this and happy to share and follow.
Take care and have an awesome day.
Yes, it’s a lot to digest! Good luck and thanks for sharing your feedback! 🙂
Thanks for sharing the changes you’ve made along the way. What is your take on David Sun’s/Trade Busters recent changes with the additional call side?
I’m curious too….listened to the TradeBusters ERN Strangle episode. I like the metrics. I couldn’t find anything about it on this site. Was this your trade or his adaptation?
His adaptation! 🙂
I don’t include the Call option side. David Sun can do what he wants but with the Call side, I would no longer consider this the ERN Put Strategy. 😉
Thank you for your clarification. I was also very confused when he mentioned the ‘ERN put strategy” on his podcast.
Regarding stop-loss, have you considered protecting the downside with a long put further OTM? The rationale would be that when your short put is ITM, or close to it, the premium to close your position will be much higher than it would have cost you to buy a put further OTM when you first short your put. I agree that this strategy would cost you some of the premium, but should also protect you from large drawdown. Have you run any backtesting on a short put, vs a put spread?
I considered that but neve implemented. The STP works and the long put would just eat into the profits.
No backtests yet. There is a site “Omega Options” where you can backtest such strategies. Might spend the money at some point and see if that helps.
Thanks ERN for suggesting Omega Options. Their pricing is reasonable, especially if it can avoids picking a wrong strategy costing a large L in the P&L. I previously checked out other solutions like ORATS or Historical Option Data, but they are more pricey.
Yeah, Omega seems to have a pretty neat simulation tool. Might be worthwhile to check out.
Hi BigERN, There has been some buzz recently about 0DTE/short-dated options “causing the next market meltdown”. Surely overstated though we did seem to see a lot more intra-day volatility in 2022. Curious if you have any thoughts to share?
I’m not losing sleep over it, but it could certainly cause a small flash crash in conjunction with some other market disruption, e.g., a fat-finger mistake, etc.
Thanks for the update post to your strategy! A couple questions:
1. You mentioned you sold a box spread at around 3% interest. Today’s rates that I am seeing are closer to 4.8%, so I assume you sold the spread earlier in 2022. How has the open box spread behaved since interest rates have continued to climb…do you have essentially an open “profit” on the position?
2. At todays rates, have you considered something like SHV (treasuries with yields <1 year)? It has around a 4.25% yield right now and is not very rate sensitive. I like parking my margin cash there, and then moving it to something else if it becomes more attractive. It seems like lest interest rate risk than preferred shares, longer dated treasuries, etc. As an aside, I do like your preferred shares idea. In addition to the nice yield now, they should get a boost if/when interest rates start to lower, resulting in some nice capital appreciation correct?
If interest rates climb and you hold a short bond you make money.
I don’t buy the SHY. If I have money left over I “Lend” through a long box spread and target the Dec 2023 or Dec 2024 expiration. Now the income I make from that trade is 60% LT and 40% ST capital gains. Better tax treatment than the ordinary income from SHY.
Wow, great idea to “lend” via the box spread. Do you just customize your SPX strikes to get the target amount of cash you want to deploy? Do you like specific expirations (for example, you could lend on something 600+ DTE but also from 100 DTE, you would “collect” the same interest rate, right?)
I only do 1DTE or 0DTE. Occasionally a few contracts with 30-90DTE very far OTM. But my bread-and-butter business is the short-term put selling.