March 7, 2024 – My claim to fame in the personal finance and early retirement community is my Safe Withdrawal Rate Series, which has now grown to 60 parts. But I also have another passion: trading options to generate extra income in retirement. By popular demand, I like to update everyone on how my strategy has evolved since my last update in early 2023. Before I do that, though, I also want to reemphasize the rationale for my options trading strategy: Why does it work? How does it fit into a portfolio, both during accumulation and now in retirement? How do we dispel some of the common objections and misunderstandings? I think of it as an options trading primer.
Let’s take a look…
The strategy in a nutshell
I’ve written about this strategy in previous posts, most recently here. But briefly, here is what I’m doing:
- Keep a portfolio of productive assets (bonds, preferreds, stocks, etc.) in a taxable account at Interactive Brokers.
- Sell short-dated, far out-of-the-money naked options on margin for additional income. I use the CBOE SPX options (100x multiplier), i.e., options on the S&P 500 index. These are cash-settled European options, and they qualify for the advantageous Section 1256 tax treatment. Even with potentially thousands of trades, there is no need to itemize your transactions on your tax return. You simply enter the net options trading profit, one single number, on IRS form 6781.
- Very occasionally, you suffer a loss if options go “in the money” to a stop loss is triggered before then. But long streaks of making the full premium are usually enough to compensate for that. So far, I’ve made money with the strategy in every calendar year since 2011. In every market condition: bull markets and bear markets. March 2020, the height of the pandemic panic, was my most profitable options trading month ever.
- You make money (on average) because the option implied volatility is far higher than the average realized volatility. I will provide some stats below!
- If you trade this daily, you have about 250 independent investments per calendar year. Each individual option trade may have a highly non-normal and negatively skewed return profile. But averaging over enough independent trials, you again make returns (mostly) well-behaved. They even approach a Gaussian Normal, compliments of the Central Limit Theorem; see Part 3 for more details.
Returns since 2018
Why 2018? I’ve been trading options since 2011, but the account size was much smaller then, and I ran this strategy and a few others with much higher risk and return targets. In 2018, this IB account went to “prime time” when we sold our San Francisco condo, and a large part of the proceeds went into my Interactive Brokers account. That’s also when we started funding our retirement expenses out of this account. Average returns would look even better when including the early period (+100% in 2012!!!), but it would be comparing apples and oranges.
Here’s my options trading cumulative alpha chart; please see below. I should stress that these are the returns from the options trading part only. You trade options on margin, and the underlying portfolio, comprised of cash, preferred shares, and equities, is separate. Thus, your options revenue supplements your underlying portfolio. Even +0.1% p.a. would be a win, but I did better than that.
There were a few drawdowns, but they didn’t last very long. Each down/up cycle was much faster than your average equity bear market. I got caught in the early 2018 vol spike right out of the gates. 2020 started with two down months in January and February, though the March 2020 blockbuster return made up for that again. So, quite intriguingly, the early part of the 2020 bear market caused some losses, but the really volatile month of March 2020 made up for it. As I explained in my last options post, the first half of 2022 was a bit choppy. But overall, this was a very successful strategy.
For the month-over-month excess returns, please see below. As mentioned before, since late 2022, I’ve walked down my return and risk target as a percentage of the account size. That’s really all the money I need to generate because I also have the dividend and interest income from the underlying portfolio.
And some return stats, please see the table below. I list the annualized return and risk and the Information Ratio (IR), i.e., the excess return per unit of risk. One can think of the IR as the Sharpe Ratio equivalent for an alpha strategy because you subtract the benchmark (e.g., the underlying portfolio) instead of the risk-free return in the numerator. In fact, if you implemented this options trading strategy with a risk-free asset as the underlying asset (money market, 3m T-Bills, etc.), then your Sharpe Ratio equals the IR. Notice that a 3.0+ IR is phenomenal. Even an IR of 1.0+ is already quite impressive. The stock market Sharpe Ratio is about 0.30-0.35 (if you think of the Sharpe as an IR with a cash benchmark). 14.0+ over the last twelve months is astronomical, though it should be taken with a grain of salt due to the short horizon and the remarkably calm market environment. But it certainly makes for a good conversation starter in finance circles!
The walk-down of average returns is also noticeable in the all/5Y/3Y/1Y return stats. It’s not because the strategy performed worse (in fact, the IR increased over time); it’s simply because I’ve treaded more cautiously over time.
Does Options Trading Generate “Alpha?”
I recently discussed options trading on Twitter, and a fellow personal finance influencer scoffed at my claim that I generate “alpha” with my options trading strategy. Well, the proof is in the pudding. The charts above prove that I received additional returns over and on top of the underlying portfolio, so by one definition, that’s undoubtedly an alpha strategy. But I like to use a narrower definition:
Alpha = an excess return not attributable to the market and/or style factors.
So, we can think of this as an estimate for the average excess return, but accounting for exposures a market factor or benchmark and sometimes other style factors, e.g. the Fama-French SMB and HML factors and others. In other words, it’s the intercept in a univariate or potentially even multi-variate factor regression model. The advantage of this approach is that we can separate returns into simply capturing risk premia – the part modeled by the beta factor loadings – and the left-over intercept, i.e., excess returns that look like alpha: skill, market timing, stock picking, arbitrage, market making, etc.
I took my Put Writing returns and regressed them on both S&P 500 and the CBOE Put-Writing index, see here for more info and return data. So here are the regression results; see the table below:
- Model 1: There is slight exposure to the S&P 500, though the weight is minimal. While the 3% beta is statistically significant, it’s economically insignificant. The alpha is 7.12%, which is highly significant with a t-stat of almost 7. The R^2 is minuscule, too.
- Model 2: The ERN strategy also has a tiny correlation and exposure to the CBOE put selling index. However, the beta is both statistically and economically insignificant. The R^2 is even lower than in Model 1. The alpha estimate is now 7.39%, the t-stat at 7.19 indicates a strong statistical significance.
- Model 3: By adding both market betas to the mix, we certainly increase the R^2, though it’s still below 0.10. The SPX beta is a bit higher, but intriguingly, the PUT index beta is now negative (likely the effect of multicollinearity). The alpha estimate is still at 6.92% and still highly significant.
How about a kitchen sink model? Because I have the seven return series handy in my Safe Withdrawal Rate toolkit (See Part 28 of the series for more details), I can run a regression model with those seven factors. Please see the table below. Why would I use equity-style factors like SMB and HML on an equity index options strategy? No idea! I just throw everything at the wall and see if anything sticks! In any case, we still maintain an alpha of almost 7%. The factors are all in single digits and mostly offsetting each other (e.g., +5.52% SPX but -1.59% international stocks, or +7.87% 10Y bonds and -3.93% 30Y bonds). So, nothing captures my return series. It’s mostly alpha!
It doesn’t necessarily mean the intercept is genuinely due to skill, though. That’s because of (at least) two reasons: 1) the alpha may be beta in disguise, i.e., we might have forgotten to include all relevant market betas and styles. 2) the alpha could still be due to luck. Item 2 is easy to address; I ran statistical tests to confirm that the intercept was highly significant. Item 1 is a bit more challenging; we can include a bunch of regressors as in Model 4. But who knows what other factors I might have missed. Please let me know if anyone wants to run their regressions on their factors, and I can provide my return series.
How Options Trading fits into my portfolio
I must stress that nothing I’ve posted here so far means that we should all abandon our existing portfolios and go all-in with trading options. Quite the opposite, I always saw my options strategy as supplementing my existing portfolio, which is perfectly aligned with the standard passive index fund philosophy. Think of me as a Boglehead with a sense of adventure.
I’d also never recommend using excess leverage. For example, if the strategy did so well with 7.7% return and 2.5% risk, why not run this with an additional 10x leverage and make 77% returns with 25% risk? What can possibly go wrong? Check my post on the “optionsellers” debacle again!
I don’t even assume that the 3+ IR will last forever. But even assuming a rather mundane expected return of 2% and risk of 2%, thus, (thus IR=1.0) will generate impressive results. Let’s look at the following numerical example. Imagine we have stocks, bonds, and short-term fixed-income assets with the following expected returns and standard deviations:
- Stocks: Expected return/risk = 8.5%/16.0%
- Bonds: Expected return/risk = 4.5%/6.0%
- Cash/risk-free expected return = 3.25% (currently much higher, I know, but we need to factor in that the Fed will lower interest rates soon, so a 10-year average cash return is likely lower than today’s 5%+)
- Options-trading alpha: Expected return/risk = 2.0%/2.0% (For example, assume a 5% return and 5% risk in the taxable account. But the taxable account is only 40% of the total portfolio; thus, the options add only 2% alpha to the overall portfolio.)
Also, assume that the stocks-bond correlation is +0.1, the stock-options correlation is 0.5 (higher than my actual correlation, but I want to be on the cautious/conservative side), and the bonds-options correlation is 0:
Before adding options to the picture, let me plot the efficient frontier of S/B portfolios. See the chart below. Being a math stickler, I insist on drawing the efficient frontier only up to the min-vol portfolio. I don’t draw the parabola all the way to 100% bonds because the backward-bending parabola with less return and more risk is no longer efficient:
Now, let’s add the 2% extra expected return from the options trading strategy. That’s a substantial move in the efficient frontier!
Do I get 2% extra expected returns for free? Not exactly. Due to the correlation between the options trading and your stock portfolio, going from, say, an 80/20 portfolio to 80/20 plus 100% options will give you 2% extra expected return but also more expected risk, hence the move to the Northeast direction (more like NNE, actually); see the efficient frontier plot below. If I like to keep the same expected risk, I’d then move along the red efficient frontier back to about 72.5% equities and 27.5% bonds. I’d have the same risk but only about 1.7% extra expected return at that point. But a 1.7% extra return is nothing to scoff at. Not even a 100% equity portfolio would have accomplished that on the Baseline Efficient Frontier.
Because this issue came up in last month’s post, with a little bit of financial engineering, we can even push the efficient frontiers a bit higher if we take the Max-Sharpe-Ratio portfolio and lever that up; hat-tip to Dr. Cliff Asness at AQR Capital Management. So, I also include those efficient frontiers for the math and finance wizards. The leverage-based frontiers do a bit better, but the more significant boost in the return/risk tradeoff still comes from the options trading alpha!
If you don’t like my return assumptions and correlations, here’s a link to a Google Sheet you can use. As always, you must create your own copy of the sheet before editing anything!
Why trading options is an excellent FIRE tool
What kind of an impact would a 1.7% extra return have on retirement planning? Imagine you plan to withdraw 4% under the baseline, as recommended by the naive 4% Rule of Thumb. You might have to do a more detailed, personalized analysis – see Part 28 of my SWR Series for a free Google Sheet retirement simulation tool. But for simplicity, let’s run with the dumb 4% rule. If you can raise your safe withdrawal rate to 4%+1.7%=5.7%, that’s a 42.5% increase in your retirement budget. Not a bad retirement boost. Instead of 25x annual expenses, you target only about 17.5x to retire.
How much of a difference would 1.7% make during accumulation? Assume we have a FIRE enthusiast planning to save $3,000 a month for the next 15 years. With a 1.7% extra return, how much faster to accumulate during those 15 years? An assumed 5% annualized return in the baseline would accumulate to just under $800k after 180 months. With a 6.7% average return, you’d expect just above $900k, or about 14.8% more than in the baseline. And the combined effect of 14.8% more accumulation and 42.5% more withdrawals yields a (compound) 63.59% increase in your retirement budget. Sweet!
Why did we not boost the retirement nest egg by (1.067/1.05) 15-1=27.2 %? The answer is simple: this is not a buy-and-hold investing calculation. Because we regularly contribute to the retirement portfolio, only the first monthly contribution would grow to 27.2% more, but subsequent contributions have less time to enjoy higher returns. Hence, there is a nontrivial but still slightly underwhelming impact on the retirement accumulation part. You’d get better results over 40 years, i.e., the traditional retirement planning horizon.
My takeaway: for accumulation, the alpha boost from options trading is not as useful for early retirees. Sure, 1.7% compounded over 15 years amounts to an additional 14.8%. But the real impact comes in retirement when you can raise your withdrawal rate by about 1.7 percentage points. For example, I did not start trading options until 2011, seven years before retirement. And I did it on a small scale only.
So, if you’re not yet retired and have a relatively small nest egg, maybe don’t worry about options trading yet. You’d also need a minimum account size of $110,000 to qualify for portfolio margin. But options trading is certainly a powerful tool once you are close to or in retirement! There is no reliable way to get around Sequence Risk in retirement. Maybe a glidepath can alleviate a small portion of the risk. The only viable solution to retirement headaches is to raise the expected return. Everything else, like bucket strategies, etc., is wishful thinking and window dressing.
How to deal with objections
1: Options should have a zero expected return.
This is an issue I frequently encounter, for example, years ago in my appearance on the White Coat Investor Podcast (in the recording at about the 50:10 mark). Let’s go back to finance fundamentals to prove that options cannot all have a zero expected return. For example, let’s use the well-known Put-Call-Parity equation. If we buy a call and sell a put option with the same strike and hold the notional capital in a risk-free asset, e.g., T-bills, we have generated a synthetic version of the underlying. To squeeze out any ill-gotten profits, the following non-arbitrage condition must hold:
Call – Put + Risk-Free Asset = Underlying
For the options trading pros, we can even write this without the risk-free asset return if we’re trading futures, i.e., we can generate a synthetic futures contract with a long futures call option and a short futures put option.
Actually, the put-call parity equation is even an identity, i.e., no matter how the market evolves, the synthetic stock will consistently track the underlying, so we could even replace the “=” sign with an identity sign (“≡”). Because of that identity, we can also write the put-call parity in expected return terms as:
E(Long Call) + E(Short Put) = E(Equity Premium)
If we believe there is a positive excess return of equities over risk-free assets like T-Bills, the sum of the two options trading flavors, long calls plus short puts, should also have that same positive return. Thus, options can’t all have zero expected returns. You must be compensated with positive expected returns for exposure to risky equities, whether you hold risky stocks or options.
2: The market is efficient.
Related to the issue in part 1, people often point out that efficient markets negate the attractiveness of options vol sellers. I beg to differ. Returning to the Equity Premium composition, i.e., the equity premium is the sum of the downside risk premium plus the upside risk premium. Which side of the equity premium is better compensated, the downside or the upside? Do I need compensation for a call option payoff profile where I participate in all the equity upside but none of the downside? Likely not. In fact, quite the opposite, this type of positive skewness, lottery-like payoff will offer low, no, or even negative compensation, not despite but because of market efficiency. I.e., you normally pay a premium to participate in a lottery. See Dr. Antti Ilmanen’s FAJ paper for a great discussion.
If I rearrange the put-call parity equation as
E(Short Put) = E(Equity Premium) – E(Long Call)
… and the Long-Call is costly on average, then I get an expected return E(Short Put) > E(Equity Premium). So, selling insurance must be a profitable business, likely more profitable than equities, especially as a multiple of the standard deviation.
3: Black Swan events.
I agree that option selling, if done wrong, will lead to ruin during a “Black Swan” event, i.e., an unexpected and significant economic/financial shock like the pandemic or the Global Financial Crisis. For that exact reason, I’ve showcased in numerous posts over the years how not to run a short-vol strategy:
- 2017: This fund returned over 100% year-to-date. I’m still not buying it! I warned of the short-VIX futures ETF (Credit Suisse’s XIV) in October 2017, just a few months before it blew up and lost 95% of its value over three days and eventually shut down.
- 2018: The OptionSellers.com debacle: How to blow up your portfolio in five easy steps. This post showcases the risk of selling long-dated call options on positively skewed commodities, especially natural gas. The blowup of optionsellers.com was a combination of economic illiteracy, too much leverage, and a lack of a risk model. Well, they had a risk model but didn’t follow it; after the market went against them, they doubled down, lost even more, then quadrupled down, and then lost it all in the end.
- 2019: Another Option Strategy Failure: Why it’s “Nickels in Front of a Steamroller” and not “Benjamins in Front of a Baby Stroller!” UBS sold an Iron Condor yield-enhancement strategy. Quite intriguingly, it didn’t even take a black swan event, but merely a garden-variety choppy stock market in late 2018 and early 2019 to cause massive losses.
- 2021: Passive income through option writing: Part 7 – Careful when shorting long-dated options! My general advice is that selling long-dated, far out-of-the-money options is not free money and poses a significant risk. Even assuming that the black swan shock is not large enough to send the underlying beyond the strike; if there is enough time to expiration, the Delta, Gamma, and Vega effects will cause enough losses to wipe you out. As happened with optionssellers.com.
What all these accidents have in common is that shorting long-dated options (or VIX futures) can go awry during black swan events. With a market move and a vol spike large enough, that short option can lose a ton of money compliments of the options Greeks, especially Delta (change in the option price per unit of underlying change), Gamma (change in the Delta per unit of underlying change), and Vega (change in the option price per unit of implied vol increase)! And I know, Vega is not even a Greek letter! But that’s much less of a headache for 0DTE and 1DTE options. You don’t go from a 2006-style stock market to the 2008 Lehman Brothers failure literally overnight. You don’t go from a 2019 market to a March 2020 pandemic market overnight. The volatility usually builds over time. So, with 1DTE and 0DTE contracts, you successively sell strikes farther out of the money. When March 2020 came along, all the calm weather options you sold in 2019 had already expired, and the options you sold the day prior were so far out of the money that even the 12% drop on 3/16/2020 didn’t get close to my put strikes. 0DTE and 1DTE options work beautifully during those Black Swan events, while long-dated Short-vol strategies get clobbered. If the UBS strategy hadn’t sunk in 2019, it would have failed even more spectacularly in 2020.
So, to sum up, my live trading survived the bear market in 2022, the black swan in 2020, the volatility spike in 2018, and several other crazy market moves before then, like the Brexit vote in 2016, the 2015 Chinese devaluation, the 2011 US debt downgrade, and a few more. I ran some backtests, and I would have done great during 2008 as well. Trading options can succeed even in Black Swan scenarios!
4: Negative Skewness
A valid concern is that the standard deviation may be an incomplete measure of the risk of many options strategies in light of negative skewness. I agree. That’s precisely the reason why some of the longer-dated option-selling strategies fail. You can suffer left-tail losses that are severe enough never to recover, see the XIV ETF debacle I mention above. A sequence of several bad days will sink your longer-dated short-vol strategy. But with 0DTE and 1DTE contracts, you reset the strike constantly.
For example, my daily return skewness is -2.4, but my monthly and annual skewness are each almost back to zero; -0.1, to be precise. That’s less skewness than even the S&P 500. Thus, resetting each gamble each day (or even twice a day with 0DTE and 1DTE contracts), you start getting the benefits of the Central Limit Theorem, and your longer-range returns become more Gaussian-Normal. Not so for your long-dated short puts because your daily returns are no longer uncorrelated thanks to the options Greeks.
So, my response to the skewness concerns: I share those concerns, but if you can keep day-to-day returns “mostly” independent of each other by keeping your DTE as short as possible, skewness washes out over longer horizons. You’re barking at the wrong tree. Your and my equity index funds likely have the same or worse skewness stats over longer horizons!
5: But, but, but… I read somewhere that negative skewness is terrible!
I might be beating a dead horse now, but I would like to bring up another issue and misunderstanding of the “negative skewness apostles” out there. In fact, let’s assume that even when averaging my 0DTE/1DTE option trading profits over months, quarters, and years, I still maintain negative skewness. Even more negative than equities. Some mathematically illiterate folks will tell you that that’s bad and you should thus avoid options trading. But that’s a fallacy, and I would like to demonstrate it with a simple numerical example. Imagine someone offering me the following gamble: With a 99% chance, I make a +1% return today on my total net worth. And with a 1% chance, I make only +0.9%. Would I take that gamble? Absolutely! It’s an almost guaranteed return of 1% in one day, and even in the worst case, I still make +0.9%. What a fantastic deal!
But, of course, reality often creates more complicated tradeoffs. How about if the 1%-chance outlier gives you a 0% return? Still attractive! Or -10%? Still acceptable! At what point would I say, “No, Thank You”? At -20%? Or -50%? Or -100%? To help with that decision, let me display the return stats of these various gambles in the table below: mean return, standard deviation, and the skewness of the return distribution. Unsurprisingly, the worse we make the worst-case 1%-chance outcome, the lower the expected return and the higher the standard deviation. But did you notice what didn’t change? The skewness is the same for all. Skewness alone cannot guide us in determining what’s too risky.
So, what causes this quirky result? Skewness is a unitless measure of how lopsided the distribution’s tails are. Unitless because in the skewness formula, you calculate the third central moment of the distribution in the numerator but then divide again by the standard deviation-cubed.
Because you normalize by the standard deviation, all six gambles must have the same skewness. If someone tells me I should ignore standard deviations and look only at the skewness, I have to roll my eyes. The answer should be more nuanced. I want to look at the skewness and standard deviation in concert. For example, I would probably pass on the gamble with the minus 20% downside risk. Sure, it has a standard deviation of only 2.1% (about twice the long-term average daily stock market volatility) and around 30x(!) the average daily stock return. But why would I risk 20% of my net worth for a measly +1% on the upside? So, I agree that the mean and standard deviation alone are not very useful when you can have a ten-sigma downside. I would certainly agree if the gamble involved an expected return of +0.79% with a 2.1% standard deviation and zero skewness or equity-like skewness of around -0.50.
In other words, negative skewness is only a problem if the standard deviation is large enough that you wipe out your portfolio beyond repair. If you have skewed returns that occasionally give you a minus 10-sigma event, but that minus 10-sigma event still leaves your portfolio largely intact with a potential to recover in 3-6 months, then I’m completely fine. And that’s why I sleep peacefully with negative skewness! Scaling your bets is crucial. With an appropriate risk model and risk controls, you can and should accept negatively skewed returns.
6: I’m a glorified mutual funds salesman (a.k.a. financial planner) and don’t want my clients to know about options trading!
Yeah, I met those folks on Twitter, too. You’re beyond saving. I feel sorry for your clients. I showed a way to generate alpha with a very impressive IR. If you don’t find that IR intriguing, it says more about your skills than mine. And let’s not forget, you also generate 1%+ alpha. Unfortunately, it’s minus 1%+ alpha in the form of an AUM fee.
7: Aren’t you afraid of a repeat of October 1987? (added on 3/20/2024)
My response is that historically, significant S&P 500 drops don’t occur out of the blue. A significant drop normally (not always) occurs when implied volatility is already elevated. Qualitatively, that’s a good answer. As suggested by a longtime reader, Figuy, it would be nice to quantitatively understand how likely a significant one-day move is, conditional on different VIX regimes. For example, what were the worst historical one-day drops conditional on the VIX index hovering around just under 15 (as in the March 2024 environment when Figuy asked that question)?
I looked at the daily S&P 500 returns since January 1987 and the VIX level on the previous(!) day. So, I pair each daily return between T and T+1 with the VIX at the close of date T. We don’t want to pair T to T+1 returns with the T+1 VIX level because a deep dive in date T+1 would also raise the VIX. Instead, we want to know how much we can glean from today’s VIX level about the prospect of a significant S&P 500 drop tomorrow.
Notice that the VIX index started in 1990. Before that date, I used the alternative, differently constructed but highly correlated VXO index to backfill the first four years of data to capture the all-important 1987. I bucket the returns and the VIX into different intervals. For returns, I am only interested in the downside. So, out of 9000+ observations, I calculate the following matrix. The return bucket (in %) are the rows and the VIX/VXO buckets (in points) are the columns:
The worst return (more than 20% down) occurred on October 19, 1987. There was no drop between 15 and 20%. The second-worst drop occurred in 2020 during the height of the pandemic bear market. We have all the usual suspects in the category of 7-10% drops, i.e., another drop the week after the 10/19/1987 fall, four drops during the Global Financial Crisis, and two during the pandemic. All of them with high VIX levels the day prior. You would not have sold put options only 3-4% out of the money during that time (if the 1DTE options had been available then).
That said, if we look at the still-very-painful S&P drops in the 5-7% range, there was one day in 1989 when the VXO was below 20. So, there have been some out-of-the-blue drops in the index, but they are rare. Again, many significant market drops during the Global Financial Crisis happened when Vol was already very high.
Finally, I also want to display the conditional empirical probabilities. So, conditional on being in a certain VIX regime, what were the empirical probabilities of large S&P 500 drops:
After this long-winded analysis, Can we experience a major drop that will knock out my current (March 20, 2024) puts? Yes, for sure. But historically, the largest index drops occurred when the VIX was already far more elevated than the current level (13-14 in March 2024).
Strategy Evolution
My options strategy has obviously evolved, and in 2023, I’ve made the following (minor) changes:
- A low premium target: I’ve reduced my premium target from $0.50 per trading day to only about $0.10 to $0.20.
- Leverage: I use about $135,000 of my underlying capital per overnight short-put contract. That’s well above the minimum margin requirements, usually around $45,000 for each put, but certainly less than the notional exposure.
- Margin constraints: The 1DTE and 0DTE puts take up a ton of margin, so when I get close to the NYSE close (1 PM my time zone), I can usually trade only about half the new 1DTE puts for the next day before the top of the hour. I’d need to wait until a few seconds after the NYSE closes for my margin to return. On paper, that’s not a big problem because the CBOE options trade until 1:15 PM. But the market gets really quiet, and the juicy premiums often disappear.
- Aggressive 0DTE Put selling: At the market open, if my puts that expire later that day appear “safe,” I am comfortable selling additional 0DTE puts expiring that day as well. I usually target around $0.10 premium.
- 0DTE Call selling: People have been bugging me and asking why I don’t sell call options. I often replied that I find it unpatriotic to bet against my country and my stock market. But in late 2023, I finally relented. I now supplement my options income with $0.05 and $0.10 premium calls. The nice part about the calls is that they don’t crowd out my margin. In other words, shorting more call options in the morning will not constrain how many puts I can short before the market closes when my margin is still tight.
- Using Stops: I mentioned this in Part 10 of the Series when I wrote about the 2022 innovations, but this is important enough to stress again. I now use stop orders as a risk control.
2023 Options Trading Results
Let’s start with the cumulative returns for 2023. I like to plot three time series: (1) gross option selling revenue, (2) net profit, and (3) cumulative losses. By definition, (2) = (1) minus (3). The total gross revenue was about $86,400. After $4,100 in losses, I netted $82,300. It was the best calendar year PCR (premium capture rate) to date, with 95.3%. Even better than the previous record in 2019 with 91.4%.
What types of contracts did I sell in 2023?
People always ask me what premium or Delta I target or how far out-of-the-money I like to go. Obviously, that changes every day. In calm markets, you’d sell only 2-3% OTM. In March 2020, I sold puts with strikes 20%+ OTM. I won’t divulge all my secret sauce here, but in a nutshell, I gauge the pros and cons of different option strikes every single time, so I ask myself, where’s the sweet spot? I.e., when picking a higher put strike for an extra $0.05 of premium is no longer worth the extra risk. I developed a quantitative risk model over the years, but I will keep that proprietary for now.
In the chart below, I plot the premiums (in US cents, though we multiply that by 100 because that’s the CBOE SPX options multiplier) and the Option Deltas. Notice that the Deltas are the absolute value. All puts have negative Deltas, by definition! Also, note that the units are in Delta points, so 1.2 means a numerical Delta of 0.012. All option Deltas are between 0 and 1.0 in absolute value, but in finance lingo, a 1-Delta means 0.01. In any case, most of the overnight short puts had premia between 10 and 25 cents. Same-day puts around 10 cents, and same-day calls between 5 and 10 cents. Most Deltas were between 0.004 and 0.010.
And more options stats: The overnight puts mainly were between 3% and 7% out-of-the-money. Same-day puts between 2% and 3%, while the same-day calls are between 1% and 2% OTM. The implied vol was between 20% and 40% for the overnight puts. That’s significantly above the realized volatility in 2023 (about 0.8% daily or 13% annualized, assuming 252 trading days). Of course, the intraday put and call IVs are lower but still above the realized open-to-close return volatility.
So, it was a successful year. I made more than $80k in trading profits. This is after working about 10 minutes daily around the market’s opening and closing times. And capital gains, dividends, and interest from the underlying portfolio are extra!
2024 YTD Options Trading Results
The same reporting format as in 2023:
From January until early March, I’m up about $17,500. The premium capture rate (PCR) in 2024 YTD is 91.5%. I had two minor losses so far. The larger of the two occurred on January 11 when some of the intra-day puts got stopped. Ultimately, the market never even got close to my strikes, but a rapid intra-day drop triggered a Stop-loss buyback. Better safe than sorry. I like to have a few false alarms where I lose $1.00 on a contract instead of one significant loss on a put that 20+ points in the money.
Looking at the same type of contract stats in 2024, we find that premiums have further deteriorated. Most of the overnight puts only fetched a $0.10 premium. Occasionally, I scraped the bottom of the barrel with only $0.05 overnight. That’s an artifact of waiting until after the market closes for the margin to come back. Sometimes, even the $0.10 put strikes were too close to comfort, so I just gave up and did the $0.05 puts. But I also sold a few $0.15-$0.30 contracts. My record premium was $0.45 after the February CPI report. I’m confident there is more volatility to come this year: CPI reports, FOMC decisions, and the November election. Good things will come to those who wait.
I still sell overnight puts at 3%+ out of the money. Same-day puts at around 1.5-2%. So, usually about 75-100 points OTM at the open. I would occasionally sell some additional puts later in the day, which explains the blip around 1% OTM in the 0DTE Puts histogram. Same-day calls are also mostly about 1.5% OTM. There is slightly less upside than downside risk, so if you sell the puts at 100 OTM for a $0.10 premium, expect the calls to be around 65-70 points OTM. Implied volatility is also not too different from the 2023 picture. The overnight IV is mainly 20-50%. Like in 2023, it’s far higher, regularly 3x the realized volatility, 3x the 1-day VIX, and 2x the headline (30-day horizon) VIX index. So, again, the significant disconnect between implied and realized volatility shows me that there’s still a fantastic profit opportunity.
Conclusion
There you have it. I outlined my options trading philosophy once more. While my mechanics might have slowly changed over the years, the rational and profit opportunities remain intact.
I also reported my 2023 earnings. On a separate note, my underlying portfolio (preferred shares and equity index funds) also did very well in 2023 (+15.85% without the options trading and +20.83% combined, i.e., with the options). The fact that I haven’t written much about options is not that they have ceased to be successful. Quite the opposite, it’s such a reliable, albeit boring, money-maker that I didn’t feel like writing much recently. I will keep you posted if anything changes!
Lot to unpack. Just so I can understand a bit more, the return is calculated on the account size, but most of the account liquidation value is allocated to more traditional stocks and bonds?
You never take delivery on the underlying? If the underlying moves against the option you’ve sold, you’ll hit a stop loss as opposed to taking delivery?
If so, how do you size how many contracts you can sell?
Let’s say you have a $1m net liq portfolio, $800,000 in stocks, $200,000 in bonds. Do you sell puts such that if assigned, you would have to use $1m in margin to purchase the underlying? (Even though you would stop loss instead, I’m just asking to get an idea of the proportion of the sizing).
Do you sell more contracts since they are so out of the money and the time to expiry is so short it’s very unlikely they get assigned?
I’ve been loosely selling options on my account, covered calls and cash secured puts. I’ve wanted to maintain 60-120% exposure to the S&P.
Given the bull run, a lot of those covered calls ended up leaving me with cash. I’ve sold cash secured puts to get back market exposure, but given these are all cash secured though, it usually leaves me underexposed to the market. I’ve been wondering whether I should be more okay allowing assignment to just eat up a bit of my margin, taking me to 1.2x, or should I manage assignment more actively with a stop loss or rolling the option.
I sell options with around 45 DTE at about 30-50 deltas. Would be interest to know more about the advantage of doing this with 1 DTE or 0 DTE, though I doubt I would be able to consistently montior things daily, even if it’s just 10 minutes a day.
Yeah, that’s the headache with stock options that are settled physically. It’s exactly the reason why I’m holding my long-term assets independent of the options trading. And then just trade the SPX put options for extra income.
45 DTE will expose you to the black swan events I mentioned. But I understand that not everyone has the bandwidth to trade as regularly as I.
Correct.
No. CBOE SPX options are cash settled. Even without a STP order I would simply pay out the $ amount in the money.
Sizing: I sell one put per $135,000 of underlying capital. Theoretically if the market were to decline by the points OTM (maybe 200) plus the 135k/100 = 1350 points, I would indeed wipe out my entire account. I don’t see the market dropping by 1550 points in one day, though.
It might gap down and go back up! Has happened in other futures certainly in more wild EMs. I would never do this! Even a technically error would get you fighting for trade busts. I’ve had a ZB future few months out move big and wiped the floor with me that day. Careful !
Agree. I will not do the overnight STP orders anytime soon.
1550 points _at expiration_ would wipe the account; but isn’t it possible that while the market is dropping by “just” 700 points, IV shots up so dramatically, that the puts appreciate in price to the same level they would with -1550 points at expiration, that is – your account would be wiped out as well just because of that 700 points drop?
This is a concern for long-dated options: Imagine you write a 1y short put. The market tanks but doesn’t even get close to the strike. You can still use a lot of money, compliments of delta/gamma/vega. It’s less of a concern intraday.
Thank you for the reply, I see you point, with 0DTE or 1DTE IV is essentially curbed by the extremely short time to expiration.
Correct! In contrast, if you write a 1-year put when the VIX is low, then with enough bad shocks, much higher IV (vega effect) the index dropping (delta+gamma) you can suffer great losses even if the index doesn’t drop even near the strike.
Very interesting. I did this for a while and it was very successful but decided to stop when S&P went to record highs in 2022 and my life got busier – perhaps I need to reconsider!
“The fact that I haven’t written about options is not that they have seized to be successful.” You probably meant “ceased” rather than “seized” in this sentence?
I’m glad you found this interesting. Through ups and downs, I’ve always maintained my trading. There is no bad time for options trading.
Thanks for the spell-checking! 🙂 I corrected that already! Seize vs. Cease, Break vs. Brake, etc. are always challenging.
Congratulations! You are the only person in the FIRE sphere that tangibly makes a positive difference in everyone’s life’s!
Thanks, Karl! Always appreciate your feedback and praise!
If I could apply what ERN writes. Most posts I don’t understand cra*p…it’s written for only the nerdvana out there
Thanks. Agree. My blog is the deep end of the pool, Samuel!
Thank you ERN for continuing to be the undisputed heavyweight of our FIRE community (and an alpha manager to boot, which no one else in the community is doing to my knowledge)!
1) On managing stop-losses, how do you set these up? Are these immediate market order “dumps” once stop premium (or underlying) is breached? How about gap-down overnight?
2) Everyone is talking about 0DTE and the next volpocalypse. I’m just thinking of the theater and theater entrance analogy, when all partcipating institutions rush for the exit when an IV event requires them to buyback their contracts (and can drive even ATM premiums to ridiculous levels). Do you worry about this at all?
Cheers
Derek
I’m with Derek….I’d like to hear more about how you determine your stop amount and how you manage them….resting stop market order or an alert of some kind.
Thanks for the update.
2 weeks to 2 months worth of premium is the STP loss. It’s automated. I set the STP and let the exchange execute it if needed. It takes the emotions out of the process.
Thanks, Derek!
It’s the IB order setting “STP” so it’s a market order dump if you trigger the set price.
Currently, I’m confident that my overnight puts are sufficiently OTM that the market doesn’t move that much. But I am prepared to take an occasional loss of more than the usual STP loss overnight. But notice that none of my puts ever got in trouble during March 2020, when we had a lot of gap-down events. Over the last year, most of the big moves come from intra-day losses, which were very controlled.
I’m mildly concerned about the volcalypse. People with the ATM puts or 20-Delta will be the most impacted. My far OTM puts have always done OK during past flash crashes.
Hi BigERN! Great write-up as always.
Just wanted to chime in here to note that if people do elect to use overnight stop loss orders on IB you need to select “Outside RTH” if you want it to be filled before market open. Probably obvious to some, but I learned the hard way on February 13th, as I’m using a bit higher delta than you and the overnight downward movement led to a stop loss fill $2 higher than my limit.
I also wanted to note that IBKR is now charging an “exposure fee” – it seems like this has always been around but they revamped their proprietary algorithm to penalize shorting OTM puts. I have PM activated and I get dinged about $1.50/day including weekends running 2 overnight contracts at a 3-4 delta at 5x leverage even with mostly T-bills as collateral.
Any offsetting SPX position negates the fee – I’ve been experimenting with opening a 7DTE long put for $1 and rolling it out 7DTE when it decays to $0.50 or taking a profit at $3 if vol ever increases again. Definitely a drag right now but avoids the fee and provides a bit of downside protection until we can walk down our strikes.
Thanks for weighing in. That’s a concern. With low liquidity, your STP might trigger overnight and do more harm than good. I will likely hold back with the overnight STPs.
At my current overnight volume I can avoid the exposure fee. Sometimes I get some additional puuts overnight if the premium is OK, i.e. 0.15 and above. And pay maybe $1 fee each. Not the end of the world. But I would avoid that over the weekend because the exposure fee is more expensive.
Good to know that the exposure fee is something you’re seeing as well, and it kicks in at roughly the same notional leverage I’ve observed as well.
I’ve been considering opening an account at a competitor like tastytrade to take advantage of a sign-up bonus, but I’ve already invested a lot of time into IBKR’s platform. I have a “Family and Friends” account which allows simultaneous execution of trades across several accounts I manage. Likely something that you are familiar with based on your Twitter comment about offering this as a service.
The family and friends account is what I already do, correct. If I’m out on the ski slopes or on vacation, a friend can trade on my behalf.
Obviously a big bump up in commissions and trading spread, but any previous/current consideration toward simply caping the loss with a long put below the short put strike? No worries about nuclear weapons going off, volmageddon or wacky overnight/intraday pops that trigger the stop and return to mean after taking your money. Is a bull pit spread just “too” costly in your analysis?
Yes, the put spread is too costly.
“Any offsetting SPX position negates the fee”
Do you have more details or examples of this: for example you open a 7DTE put vs how many positions? Does one put like this offset everything or a portion of the short puts?
I don’t use that approach, so I don’t have concrete examples. But imagine that one day I’d have – accidentally – too many short SPX puts. I could certainly buy a few long SPX puts further out of the money. IB calculates the exposure fee using a 30% 1d loss. You’ll shave a lot of that loss if you have a few long puts maybe 5%-points further OTM than your short put strikes.
Hi ERN,
I was wondering if you could elaborate more on your stop loss ? I know you mentioned that you changed your position on stop loss in 2023 but if I remember before you would just let them expire whereever they are.
Also thanks for sharing your new process and the selling of call options. I haven’t sold calls myself, but the short term structure far OTM may make sense. Lately I have done 0 DTE, but I may start at least having some positions overnight. Having a position overnight even a few minutes to the prior day close makes a big difference in being able to secure a better strike.
Thanks again for your blog !
There’s nothing to elaborate: you sell a put and set a STP at somewhere 2-3 weeks worth of income. Then hope you suffer e a loss only every 2-3 months.
Just to clarify (I’m new to options). Can you confirm these are the setps to set a stop loss on a sold naked put?
1. Sell the put, wait for it to fill
2. Go into the filled put order and select close the position with a STOP order type
3. Enter in 2 weeks of premium for the STOP price (i.e. premium of the sold put x 10)
4. Enter GTC (good ’til canceled)
5. Submit the order
Is that right? Any other suggestions.
Correct.
Though, for intra-day options, #4 is not necessary.
Probably, not even for the 1DTE puts because I usually wait until the next day’s open, so the STP is only in effect for the final 6.5 hours of trading for that contract.
Great writeup Karsten!
I run a similar strategy at various DTE dates and last year it went surprsingly well. This year however, or more since the big runup last november, there has been less juice in the squeeze as implied vols have come down dramatically. Interactive Brokers recently had a webinar showing this and one line that stuck out was that the Nasdaq has been up 15 out of the last 16 weeks – which is pretty wild. Anyway, I’m not hoping for a market collapse but I do think this one way up market has been a bit rough for this strategy even with strikes resetting daily. I am taking a little more risk on premium than you and that is probably why I’ve seen some struggle with it lately.
On that note my question for you would be on comissions. Interactive Brokers charges 65 cents a contract and the exchange tacks on another 50 or so and there are some other smaller fees. My comissions turn out to be about ~$1.23/contract. If you are selling 5-10 cent contracts for $5-$10 (100 SPX multiplier), then are comissions eating 10-20%+ of you premium away per trade? I absolutely see the appeal of the lower premium from a risk perspective but the comission drag on a 5 cent option seems a bit extreme. Let me know if you’re just paying it as a cost of doing business or if you found some way to mitigate it.
Thanks again for all your excellent content over the years!
Jess
Yes, commissions are substantial. I pay $1.20 total one way. All income I report is already after commissions.
Seems like a huge time investment! Is it really worth the time when comparing this strategy to a simple buy and hold?
$80,000 a year for a few minutes a day. Not a bad hourly salary.
Wow all that? You must have a huge nest egg if you don’t leverage.
You should make a video on how to setup this on IB. Less theory and more practice
I do use leverage because I use only $135,000 in underlying capital per 1DTE put, but they all have a notional value of around $480,000 (if selling a 4800 strike put).
I’ll think about the video part. I don’t want to give too many secrets away, though! 😉
Thanks for the amazing writeup as usual! I’ve been following your posts on this strategy and implementing a variation myself since 2020, with similarly successful results. I’m confused about some of your numbers here though – is your first “return stats” table (~7.7% CAGR) for the entire portfolio strategy, or just the options premium part?
I ask because if your average premium is $20 per $135,000 of capital, then even with 100% premium capture this only gives 3.7% total return per year. And later you say “For example, assume a 5% return and 5% risk in the taxable account. But the taxable account is only 40% of the total portfolio; thus, the options add only 2% alpha to the overall portfolio.”
But how could you ever get a 5% return when the absolute max is 3.7% ?
The $135k is only for the overnight puts. I do additional puts and calls with 0DTE. That generates around 5% gross. Not much less in net terms because I haven’t had major losses for more than a year.
Hi Karsten, the options trading posts are always my favourite.
How much do you set the stop loss at?
Usually between 2 weeks and 2 months worth of premium.
Karsten, I just wanted to say thank you so much for your blog. I recommend it to people regularly. And these options posts have been so helpful to me. I’ve devoured each post multiple times including the comments and your responses.
This is my first time to comment and I wanted to ask a few questions if that’s ok:
1. I think what has kept me from going all in with this approach is my concern about overnight gap risk and a potential 3%, 5%, or 7% gap (like 2001) that blows past your stop loss and causes huge losses. I realize this is rare but the possibility keeps me from pursuing it further. Do you have any suggestions for overcoming this concern? Or even suggestions about altering this strategy to include some kind of hedge against worst case scenario? I’ve looked into a distant wing but the $0.05 wing just eats up so much of the premium, especially if you’re looking for $0.10-$0.20 for each short put. Any thoughts on how to get a similar return with less black swan risk?
2. My schedule doesn’t always allow me to be around at market open & close. Assuming I could be around sometime an hour before close to place the next day’s trade & stop loss (perhaps sometimes 30-45 minutes before close rather than right at close), is there any reason I’d need to monitor it the next day or could I just assume the stop will catch if something goes wrong and there’s no need to actively manage?
3. Do you still wait until the next morning to set the stop after the opening candle or do you now place the stop when you place the trade the day before? On IBKR, do you have the trigger for your stop on Default or one of the other options they give (like mid, bid, double bid)?
Thanks again for all you do to serve the FIRE community and the readers of your blog.
I’m a big fan!
Thanks for your kind words!
1: Volatility comes in clusters. You can’t compare a 7% gap drop in 2001 or 2008/9 with my 4% OTM puts today. TLDR, around those events you would have sold further OTM the day before because IV was much higher.
Since I’m often selling for only 0.10 premium there is no point in buying a 0.05 to protect the wing. After commissions you end up with almost nothing. But the wing protection can work for folks with a larger Delta target.
2: If you don’t have time around the market close you can certainly trade around other hours.
3: The default setting seems to be that the STP would only be active during normal market hours, not after hours trading.
Karsten,
This is very helpful and informative…I also worry about the overnight gaps as FIRE40 pointed out. I like the idea of 0DTE options and having a stop loss set (enter these at the open, and then forget about it until the next open). Does this have less risk based on your experience? Example: Selling at the open 2% OTM 0DTE.
I haven’t looked at the premium for something like this, but my guess would be extremely low…am I correct on that? So, you would basically be hoping for a 90% win rate on this type of strategy where the low premiums add up over the course of a calendar year?
My experience is that the 0DTE have higher probability of a moderate loss. Over the last 1.5 years, none of my 1DTE puts has gone even close to ITM, not even close to the STP price. But the 0DTE occasionally do.
Of course, the 1DTE have a risk of going haywire if there is some terrible news before the open. I’ve answered to FIRE40 already: I don’t think that the gap down risk is that large, though. Large gaps occurred in 2020. But IV was so high already, my puts all survived.
Thanks Karsten … And you enter your 1DTE at the open or closeost often?
I enter the 1DTE puts at the close.
Karsten,
Thank you for your great posts. Your SWR series was a major impetus for my early retirement two years ago.
(Un)fortunately, most of my funds are in retirement accounts, so do you have any suggestions for options strategies for smaller brokerage accounts (~$50,000)?
From my research, it seems that naked puts even on XSP are unavailable to me if I have only roughly $50k, all invested in equities, in my brokerage account. Thanks for any ideas/comments.
You’d need at least 110k to use “portfolio margin” so this strategy may not be for you.
I also don’t recommend going much below $100,000 in underlying per short 1DTE put. I use about $130,000 in capital per 1DTE put. So, even independent of the exchange’s constraints, there is a minimum size per 1DTE put to keep this safe.
Thank you for the reply. That is as I suspected, so I may stick to OTM covered calls on my equities for now until I can build up my account to make alternative strategies feasible.
Yeah. At least the covered calls are OK in your retirement account. But I suspect that such strategies aren’t that profitable anymore.
Naked option strategies are not available in IRAs – so it won’t matter how much you save up.
In part 8 (https://earlyretirementnow.com/2021/10/18/passive-income-through-option-writing-part-8-2021-update/comment-page-1/) you mentioned how your assets were allocated at that time:
“30.6% options trading at Interactive Brokers,
54.1% equities in our 401(k)s, IRAs, and Brokerage accounts,
3.4% fixed income in our “cash bucket“,
11.9% real estate (private equity multi-family housing investments, excluding our primary residence).”
I recently received a large windfall for a company I sold, so everything is in a taxable account. I’m in the process of allocating the funds. I’d like to be able to try my hand at the options trading strategy you’ve outlined in the future.
I currently have a taxable Vanguard account that I was going to use for my bond and equities purchases with these funds but now I’m wondering if I should I move all of these funds to IB (or TT) instead for the underlying funds for future options trading.
You mentioned 54.1% allocation in equities 401k, IRA, and Brokerage accounts (outside of IB). Just curious if those brokerage accounts are for taxable funds and, if so, why you don’t have them in IB?
Thanks for your help!
I’ve moved almost all taxable assets to IB to keep the account size as large as possible, so I can trade there s many puts as possible. So, the % numbers have shifted a bit. It’s now just over 40% in IB.
Asset can be moved from other accounts “in kind” so without triggering capital gains taxes.
So if you made $86,400 in revenue a year selling contracts that cost about $0.15, that’s 5760 contracts sold a year? About 22 a day?
Given your risk control of $135,000 per contract, that backwards out to a portfolio of about $3,000,000? (already allocated to your regular equity exposure)
I see the delta’s are super low, but it still feels quite scary. I’m trying to wrap my head around it because that’s a beautiful looking performance line that didn’t seem to get hit that badly in 2020 or 2018.
A one day drop of 27%* wipes you, which I get is unlikely. If you’re OTM 3%, a 3% drop puts you ATM with a delta of 50? Which leaves you kind of exposed 1.8x** to the S&P. It feels like a single day drop of 3% or greater happens every other year?
Am I understanding effect of these moves? Maybe I’m just having trouble comprehending the low probabilities of the 0.007 delta and I’m just thinking in absolute terms of the cost of assignment.
It feels less scary to move closer ITM and do it with fewer contracts. I suppose the tradeoff is I get a more volatile set of returns but I know I’ll never be assigned more than I can purchase? Or does the fact that it’s cash settled mean I shouldn’t have to think about the total cost of assignment in this way.
It would be cool to see some kind of two-way table on how going up in delta affects returns. Maybe also the ratio of that money (135,000) per contract on another axis. If I can sell at a premium of $0.45 and a third as many contracts and have a similarly straight line, it “feels” easier to swallow for me. Looking at my IBKR option quotes it looks like going from $0.15 to a $0.45 in premium would take it from a 0.006 delta to a 0.025 delta.
—
*1350/5000 =27%
**Assuming SPX at $5000. 22 contracts * 100 * $5000 = 11m * 0.50 delta = 5.5m / 3m net liq = 1.8x
No. A 27% drop below the strike wipes you out. If I’m selling 5-7% OTM currently that’s a 32-34% drop in one day, which is even more unlikely.
That’s faulty math. I think in terms of standard deviations. Before the 12% drop in March 2020, the IV was much higher than today.
But I can sympathize with the higher premium target: You get 3x more, but you’d also have a few extra losses over time. The line is not that straight. Your Delta is at around 3 instead of 0.007.
It would be interesting to see some of those conditional probabilities. For example, how many times has the S&P 500 dropped by 3% when the VIX is under 15 like today
Good suggestion. I added a new section addressing that issue; please see the new section “7: Aren’t you afraid of a repeat of October 1987?”
Amazing that you are now selling 1DTE options at 3% OTM. I guess that means my strategy isn’t as risk averse: I still do 1.5% OTM. Mostly 2-delta. Average premium per contract is $0.4. Much smaller account size though.
Nice! Thanks for weighing in. More premium but also more potential for losses. It’s a tradeoff. I routinely monitor the not-so-far OTM puts and I still prefer my low-Delta puts.
Would it be possible to set a limit sell order with price right below the put strike price to protect the put option? So even a sudden price drop wouldn’t cause much of the loss.
Limit order on what?
Hi Mr ERN, Appreciate your unselfishness of sharing valuable knowledge. I am your long time follower. I mean to say stop loss. I am thinking if I sell 1 spy put at strike price X and place a short sell of 100 spy stock at stop loss price X, the spy price hitting X would trigger both. I would buy 100 spy from 1 put, sell 100 spy from stop loss short sell. But I get to keep the premium of the put. Would that actually work? It seems no risk here. Probably too good to be true.
I use a Stop Loss as well but on the option itself not the underlying, as described in the post. It will cause false alarms occasionally, but also prevent rare large losses.
You face a timing issue. The price of the underlying can drop below X intraday, trigger your STP on the SPY, but then the underlying recovers again and you now lose on the massive short position of SPY if stocks rally again toward the close.
Whatever you do with the STP on SPY, nothing eliminates the risk. What you described likely increases the risk.
Got it. Thanks! I am curious since you have stop loss to protect the loss to two weeks to two months premium, SPX never settled with underlying, why would you need capital of $13500 for contract? The worst case would be two weeks to two months premium per contract?
You can potentially lose much more than your stop loss if the market gaps down and opens below your stop loss target. Say for instance a 9/11 type event occurs after hours, the market could open the next day well below where you set your stops.
Then trade only 0DTE would avoid this situation.
No. For same-day puts you’ll still need close to $50k in initial margin, about $45k maintenance margin.
Exactly. Thanks for weighing in. Because of that, the exchange mandates much higher margin requirements.
You need about $50,000 in initial margin. Mandated by the exchange.
I use $135,000 per contract to be on the safe side.
Always good to be on the safe side!
The gain of selling put is limited, but the loss can be substantial, even rarely. So mitigating the risk is crucial . On top of stop loss, is there anything else you would do to limit the loss? Thanks!
I’m buying VIX Calls 8 months out. As a tail-risk hedge. I’m still playing around with the right recipe, hence no update in the Options Writing series yet.
Wonderful strategy and a nice supplement for retirement income.
My main gripe is it really bumps up a retiree’s AGI who might be banking for ACA or other tax credits/benefits such as FAFSA that are tied to AGI in retirement. Most of the gains come in the form of income which counts towards taxes, whereas only the dividends and capital gains gets taxed on a mostly equity portfolio.
If you’re planning on FatFiring with $3+ million for a single person or $4+ million for a couple, ACA credits will be mostly irrelevant. But if you’re retiring on a more modest $1-3million portfolio the after tax (subsidy loss) gains, might not be worth it.
Noted. There may be ranges of income where you face a large marginal tax rate. This strategy may be worthwhile mostly for fat-FIRE folks who are consistently above the ACA thresholds.
One issue with backtests of 0DTE strategies is the limited data set available. Weekly expirations have only been around since 2005 (Friday only), and daily Mon-Fri expirations have only existed since 2022. BigERN, have you ever considered trying to make a model of simulated SPX 0DTE options for earlier dates? I’m assuming that 0DTE premiums correlate closely with VIX levels, so would it be possible/useful to simulate this daily 0DTE daily for dates all the way back to 1990?
I agree. I’ve used Option Omega to do backtests, and the historical tests can then only run on the 1 day per month (pre-2005) or 1 pre week (since 2005). Which is not perfect but better than nothing.
I have my own risk model to gauge the likelihood of 1DTE options going back to 1987.
I’m brand new to options trading and I’ve never used Interactive Brokers. But I’m a couple years from retirement and I’d like to give this strategy a try to alleviate SRR and generate some retirement income. I learn by doing, but want to be careful. Looking for your advice on this approach.
1. I happen to have $110k in a Treasury Money Market at Vanguard (VUSXX). I intend to move that over an open a Interactive Brokers portfolio margin account.
2. Put the $110k into muni bonds (ABHYX) at IB.
3. Sell 1 Nano (1:1) S&P 500 Put per day for a couple weeks until I get comfortable. I know this will be a loss with commissions, but it’s a cost for an education.
4. Repeat step 3 with Micro (10:1) S&P 500 Puts, then Mini (50:1).
5. Put at least $140k total in IB account and start selling SPX (100:1) puts for awhile (year+).
6. Scale up the account to sell more contracts.
That’s a good approach. $110k is likely enough for 1 short SPX put. But I certainly understand that you want to ease into this slowly.
Hi Karsten,
Great post, as always! I’m curious about how you concluded that the SWR increases 1-to-1 by 1.7% with the expected portfolio return. To me, it doesn’t seem like a foregone conclusion without actually simulating the sequence of returns.
Thanks!
Assume you start with a portfolio that has a, say, 3.3% SWR according to my toolbox. You found a way to add another 1.7% of the portfolio value every year by trading puts. That makes 5% initial. But I agree that historically, the 1.7% of extra income are based on the current, not initial portfolio. If you have a big drop in the portfolio you get only 1.7% times that smaller portfolio. So, it’s not exactly a full 1-to-1 rise in the SWR.
What are the parameters for your stop loss? I’ve been running a version of your strategy and using a 5x stop loss but admittedly I choose that arbitrarily.
Thanks for this series, it’s made me a nice chunk of money over the years!
I’d set the STP with a loss of 2-3 weeks worth of income.
Hi Karsten,
First, I’m a big fan of your stuff and have adopted it in my planning but….
Your analysis of what actually happened during (minute by minute) the crash of October 1987 misses the mark in a number of ways and is far too sterile. The actual damage – catastrophic in many instances – that occurred to investors on margin is not captured in your look back view. Trading conditions were punishing, dangerous, often halted, and financially devastating for those on margin during the collapse and volatility. Margin calls everywhere.
In my 40 years of professionally managing client portfolios I count 5 black swans, with 4 of those since 2000. They are happening with more frequency. As Sir John Templeton said on Wall Street Week with Louis Rukeyser at the end of that week – in response to the question “What should investors learn from this?”, he replied “Well Louis, the lesson here to to never buy on margin”. Best investment advice I ever heard.
Where am I missing the mark? I wrote that I sold puts way out of the money in March 2020 when the market dropped by 12% in one day, the second largest drop in the last 37 years. I had about 4x leverage that day. And made a ton of money with my strategy. I would have done OK in 1987 as well because the drop happened mostly intra-day. Thus if I had sold 25+% OTM (like in 2020) my strike would not have been in danger. And even if it had, the drop was gradual enough that I would have suffered a moderate enough loss.
This is the problem with “40 years of professionally managing client portfolios” folks who hear the word “leverage” and misinterpret that as holding stocks with 4x leverage, which indeed would have gone wrong in 1987 and 2020. But most of the “40 years of professionally managing client portfolios” folks have neither the imagination, experience, nor options math training to understand the difference between 4x equities and options with 4x leverage. So, I can guarantee you, my view captures the dangers you described and many more dangers that you have never even heard of or thought about. My view is not sterile, yours is. I have experience trading this.
Hi ERN
Always loved your options post.
A few questions (hopefully they are not repeats as I’ve gone through the comments):
1) You mentioned you set the stop loss as 2 weeks to 2 months worth of premiums before. Is there any formula or thinking around where you set the stop loss? Is it around IV levels? And I believe you mentioned using a stop loss (market) order. Why not a stop loss (limit) order?
2) Is the 130-135K per position that you described already unleveraged? I.e. am I right to think that with a hypothetical $1.35M portfolio, you are selling 10 positions a day? Or you would take additional leverage and sell 20 positions for example?
3) IBKR charges exposure fees which was discussed above. How did you manage to avoid them, especially if you hold puts through the weekend? You mentioned above you get overnight puts if the premium is OK i.e. $0.15 or above. Assume you meant selling them? A commentator noted perhaps buying a far OTM put and rolling them to avoid so just wondering about your thoughts as this, along with the fees, cuts into the returns. I already have portfolio margin and secured against cash/T-bills so just trying to figure things out.
1: I keep the STP parameters intentionally vague, because I’m not giving away all my secrets. 😉
2: $135k per position means that in a $1.35m portfolio you sell 10 overnight puts. Not 20.
3: I avoid the exposure fee on most days. Example: index at 5200. Strike at 5000. A 30% drop would put the index at 3640. That’s 1360 points in the money. It would just about wipe out the portfolio. But you’d need a more significant loss to trigger the fee. IBKR starts charging the fee if the 30% drop would cause a significant shortfall.
Would you sell 10 SPX put on 1.35m portfolio on SPY? They are highly correlated. Or lower the number to 8 or 5 put to mitigate the risk?
Excellent question. I’d tread more cautiously in that case. I’d lower the number to 5-8 as you suggested, because of the 1.0 correlation.
1) Fair enough. Perhaps you can share some more vague ideas?
2) Is there anything that goes into your thinking around setting it at $135K? Is it because you already hold equity positions correlated to SPX? Could that $135K plausibly be reduced in a full cash/T-bills portfolio and an adequate stop loss?
3) Got it. It’s very hard to figure out how they do it because they give warnings about how it would be applied but then obviously the ‘offending’ positions are closed out. Do you know if buying long puts (and if so what deltas) solves or reduces the fees over weekends?
2: There is nothing magic about 135k. It just so worked out that with the current number of overnight puts, I avoid the exposure fee.
3: Long puts that offset the loss under a 30% down move would clearly mitigate the exposure fee.
Do you ever think about holding your safe short term cash like investments in 2 year treasury futures instead of lending out s&p boxes? You get the same 60/40 tax treatment, and they’re more liquid with similar risk/return profile. I worry about trying to get out of a box spread trade if you ever need the cash in a major liquidity crush.
Not really.
According to Bloomberg (https://www.bloomberg.com/markets/rates-bonds/government-bonds/us), here are today’s interest rates:
3M: 5.37%
2Y: 4.75%
That means you’d get a yield of -0.62% on the 2Y futures, on top of the risk-free short-term rate of 5.37%.
So, you’d still hold your principal in short-term instruments at 5.37% paying the full ordinary tax rate.
There are other short term futures contracts like SOFR as well, you can pick whatever duration you want
That creates the same problem. A futures contract, being on margin, only pays you the excess return above a risk-free rate. You still need to invest the principal in something that pays that RF rate. And that’s taxed at the ordinary income tax rate.
Box spreads lending gets around that problem and generates the interest on the principal as S.1256 income.
Please consider writing an update on box spread lending, Karsten.
I felt really bad after reading a post from the guy with the “40 years of experience professionally managing money” because he misunderstood the use of the term leverage with regards to a very safe 20% OTM strike for selling puts. But you handled the reply not only maturity, but educationally.
You explained, again, how you not only survived, but profited from the March 2020 black swan. What more do your readers need? That was a very educational reply.
Thanks!
Though I admit, I was a bit rough on the guy, haha!
Please consider writing an update on box spread lending, Karsten.
Good idea. I should write a post on lending via box trades!
The devil is in the details. If you sell $0.10 put with 2-3% OTM strike price for 0DTE put, and set stop loss at one month (0.10 x 20 trade days) premium at quote $2, 1% price down during the day would easily trigger the stop loss. 1% price down during the days happens quite often. So you may end up losing money a lot often. Something must be wrong here.
If the 1% drop is very rapid right after the open, you indeed lose money. If the drop is late enough during the day then the STP would not trigger.
For example, for 2024 YTD, here are the 8 trading days where the low was 0.9% or worse below the open.
2024-04-04 -1.87
2024-01-31 -1.10
2024-01-11 -1.10
2024-04-09 -1.08
2024-03-05 -1.05
2024-03-14 -1.00
2024-02-13 -0.96
2024-03-08 -0.91
My 0DTE put STPs were triggered on 4/4, 1/11, 4/9, and 3/14 but not the other dates. Admittedly, more than I hoped for. In 2023 I had fewer than 3 such 0DTE put losses between in the entire calendar year.
So it seems about finding the sweet spot for stop loss. Increasing the stop loss number will lower the chance to trigger it, but may pay bigger price once it triggers. Often time the put strike price is still far away when the stop loss is triggered.
That’s exactly right. It’s part science, part art.
That’s the secret sauce you have but we don’t 😀.
Thank you so much for sharing your experience! Could you comment on the data subscriptions you use to execute your options strategies? Thank you!
I have to subscribe to the Interactive Brokers real-time CBOE options data feed. But nothing else really.
This is intriguing. What’s the best way to put a toe in, do you think, to play around with it? Does Interactive have a test bed to model a portfolio or would I have to push 10K or so into it and learn about it that way.
I’m about 6 years out from retirement so learning now seems wise.
The minimum account size for portfolio margin is now $110,000 at IB. For smaller account sizes, you could try the Micro E-Mini S&P 500 futures options. They have a notional of only 5x the index, so only 1/20 of the CBOE Index options.
Commissions would eat up a lot of your profits, though.
That’s the secret sauce you have but we don’t 😀