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