The strategy in a nutshell
I’ve written about this strategy in previous posts, most recently in Part 10, Part 11, and Part 13. 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 that 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” or 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.
Why does this work? Implied Volatility (normally) exceeds Realized Volatility.
Of course, the central limit theorem is useful only if the strategy has a positive expected return. Where does this positive expected return from selling options come from? In a nutshell, implied volatility exceeds realized volatility on average. In other words, options buyers typically overpay for insurance, at least on average. To demonstrate this feature, I plot the 21-trading-day rolling realized volatility, annualized, against the implied volatility from 21 trading days earlier. Note that 21 trading days corresponds to roughly 30 calendar days.
Most of the time, implied exceeds realized. True, this calculation is relevant for the 30-day options selling only (that’s how the CBOE constructs the VIX), but similar – and often more extreme – discrepancies persist for my 0DTE and 1DTE options, though I don’t have enough history to plot this chart for 30 years. Because the market prices options at much higher risk levels, about 20% annualized on average, relative to the 16% realized risk, options sellers tend to make money. In contrast, options buyers tend to lose money.
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 Part 10, 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). 9+ over the last 12 and 36 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 supplementing my existing portfolio, which perfectly aligns 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!
How to report options trading income on your tax return
Reporting one year’s worth of options trading P&L, with potentially thousands of individual trades, is surprisingly easy if you restrict this options strategy to only S.1256 contracts. Again, gains or losses from options on the CBOE SPX index, CME index futures, or any other options on broad index products or commodity futures (gold, oil, natural gas, etc.) fall under this IRS section. You read off one single number from your tax forms, i.e., the net gain from S.1256 contracts and enter it on IRS form 6781.
40% of that gain goes to line 8 and 60% to line 9. Those numbers then carry over to your usual IRS Form 1040 Schedule D, in lines 4 and 11, respectively. That’s it! That’s the total tax season bookkeeping effort from a year of potentially thousands of trades.
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 the naive 4% Rule of Thumb recommends. 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 a FIRE enthusiast is 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 optionsellers.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 mentioned 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 skewnesses 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 to ignore standard deviations and focus only on skewness, I have to roll my eyes. The answer should be more nuanced. I want to examine the skewness and standard deviation in conjunction. For example, I would likley 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!
Yes, I met those folks on Twitter as well. 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?
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 lengthy analysis, can we expect a major drop that will affect my current (October 1, 2025) puts? Yes, for sure. However, historically, the most significant index drops have occurred when the VIX was already significantly elevated compared to the current 16+ level.
Are there ETFs worth considering?
As of today (October 1, 2025), when writing this update, I’m unaware of any ETF that replicates my strategy. There may be some related strategies packaged into ETFs, like WisdomTree’s PUTW. But the put options shorted in this ETF are 1 month ahead. I prefer the 0DTE and 1DTE put selling. I also prefer to have control over both the leverage and the underlying assets.
So, the only way you could outsource my strategy would be via a separately managed account with a trusted financial advisor. I have brought in a small number of clients into my Investment Advisory Firm, but I’m not currently accepting new clients. I am also not aware of any advisers offering this strategy (yet).
In summary, to utilize this strategy, you’d need to implement it yourself, which can be a lot of fun and excitement in early retirement!
All options trading posts so far
- Trading derivatives on the path to Financial Independence and Early Retirement
- Part 1 – Intro
- Part 2 – Extended Intro
- Part 3 – Strategy details as of 2019
- Part 4 – Surviving the 2020 Bear Market!
- Part 5 – A 2018-2020 backtest: Guest Post by “Spintwig” (plus a quick update on last week’s volatility)
- Part 6 – A 2018-2021 backtest with different contract sizes: Guest Post by “Spintwig”
- Part 7 – Careful when shorting long-dated options!
- Part 8 – A 2021 Update
- Part 9 – A 2016-2021 backtest: Guest Post by “Spintwig”
- Part 10 – A 2022 Update
- Part 11 – A 2023 Update
- Part 12 – Why the Wheel Strategy Doesn’t Work
- Part 13 – A 2024 Update
Other Related Posts
- This fund returned over 100% year-to-date. I’m still not buying it!
- The OptionSellers.com debacle: How to blow up your portfolio in five easy steps
- Trading like an Escape Artist: October 2018 update
- Another Option Strategy Failure: Why it’s “Nickels in Front of a Steamroller” and not “Benjamins in Front of a Baby Stroller!”
Options Trading Podcast Appearances:
- On the Two Sides of FIRE podcast: He Earned a Million Dollars Trading This Option Strategy (also on YouTube)
- On David Baughier’s podcast: What Are Options? The Good, The Bad, and The Profitable!
- Trade Busters Podcast: From FIRE to PCR
Other useful Info
- Options Trading basics on Fiology.
“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). ”
Have you also been able to backtest your strategy on these “worst one day drops”, including the few that were not preceded by significant previous day volatility?
I have my own returns since 2011. All fine.
There weren’t many really bad returns when the VIX was low. 10/13/1989 was the only one. It’s hard to simulate that one without actual options quotes from that era.
If you were using significantly less leverage do you think you would still use stops? In other words, how do you think using stops will impact the overall long term profitability of the strategy? My guess is that letting all trades expire would have the best per contract profit, but you’d have to trade smaller to account for the occassional large losses.
Good question. I use STPs because I don’t want to have 4x leverage on the very volatile days. But with less leverage I would feel more comfortable sitting out the losses. So, yes, STPs would become less desirable with less or no leverage.
Hello, huge fan of this series and learnt a lot from you. What kind of stop orders you place to ensure less leakage and avoid getting them cancelled. I know some brokers allowed advanced stop orders. Do you do limit or marker stop orders?
In Interactive Brokers I right-click my position, pick “Close” and then select “STP”
No STP Limit as they could be jumped over if the market moves quickly enough.
Hello Karsten
First of all, a big thank you for the great posts on your blog. I have also been an enthusiastic reader for some time now. I live in Switzerland and am interested not only in index investing but also in the option strategies you have presented. What do you use as underlying at Interactive Brokers (also ETFs on the SPX)? How does the strategy work out with leverage (due to the resulting interest charge for the broker with a margin account)?
I use the CBOE SPX index options only.
These are naked options only. I don’t buy any principal/notional on margin, so I don’t pay margin interest.
Do you ever get an Interactive Brokers “Big Margin Change” error preventing your short puts from being submitted at market close? It says the valuation on the account might be incorrect, blocking any trades. It usually clears up a few minutes after 4:00pm Eastern, but today went past market close at 4:15. I traded 1 option per $130k in account value at market open and I guess that’s too much of a margin change at market close? I might sell 1 less put at market open in hopes to avoid this “Big Margin Change” error and be able to sell puts at market close.
Never seen that one.
Options newbie here. Why do you use Interactive Brokers, instead of Robinhood? It looks like RH’s option trading is free, and IB is up to a dollar per contract. Is the fee effectively irrelevant given the premiums you are receiving, and the IB features superior to RH?
Google Robinhood payment for order flow.
https://www.wealthkernel.com/post/why-free-trading-isnt-free
Yep. There’s no free lunch! 🙂
Nothing is completely free because even at RH you would still pay the exchange fee, just no broker commission. But check it out and make sure.
I also like the more professional level of service. At IB I don’t have to fear that I’m shut out of my account during a vol spike. I have an advisor account setup (with my account and a trusted business partner’s account as “clients”) so my buddy can trade contracts in my account through our master account. That kind of setup is currently not possible in RH.
It seems you put a lot of faith in the ability of yesterday’s VIX to estimate the probability of a decrease of a particular percentage today in the SPX. Is your VIX / SPX return table roughly how you are choosing strike prices? E.g. if the VIX is 20 and you’re hoping for a 1% or less chance of a loss, you’d probably target a strike around 3.5% below current price. Do I understand your VIX tables correctly?
That said, it seems like this strategy depends on an assumed relationship between VIX and T+1 SPX changes. How are you confident that this is a real relationship and not just something that seems like it makes sense?
When I expanded your VIX / returns table out to more discrete VIX and return values, if I squint, I see the pattern maybe. But the counts of return events in the higher VIX and higher loss levels are almost all 1s. E.g. when the VIX was 54 there was exactly 1 day of 9-10% losses. All those one-off events make me feel like there’s insufficient data to rely on. I’m not a statistician though.
No, this table is just for illustration of the volatility clusters. I don’t use this table to determine my strikes.
If you have trouble seeing that the connection between a measure called “implied volatility” and the subsequent magnitude of the S&P 500 drop is not merely spurious/random but fundamental then I can’t really help you. I also stress that none of my insights here are my original inventions. The 2003 Econ Nobel Prize was awarded for understanding some of these issues, for work that was written in 1979 when I was a toddler. So, it’s one thing if you doubt some random blogger on the interwebs. It’s another if you doubt 45 years of econ/finance/stats research.
Great, we’ve identified the root problem. If you study more statistics then you don’t have to squint anymore.
Ah perhaps I did not understand the VIX itself was based on S&P directly. I somehow thought it was based on the broader market. Upon reading further I see the definition which clarifies.
Despite poring over your posts, I obviously do not understand entirely. That said, it is interesting and somewhat disturbing that the crowds consensus (at least on say Reddit) is basically that what you are doing with 0 or 1 DTEs is a recipe for disaster. Maybe they’re all thinking of highly leveraged situations.
Yes, the VIX is specifically constructed for the S&P 500 index using the CBOE SPX options.
I don’t read much reddit these days. I would have thought that the 0DTE/1DTE discussion group is where mostly supporters of this type of strategy would assemble. It’s not clear why they would be so opposed to my strategy. Is there any reddit post where they discuss my strategy in particular?
https://www.reddit.com/r/thetagang/comments/1bdwce3/0dte_far_otm_spx_puts_thoughts_on_big_erns/
I wouldn’t call it much of a discussion, but Karsten’s put selling strategy comes up here and there.
Thanks for the link. I don’t read much reddit these days, but I’m glad people discuss my strategy there.
I was thinking it’d be possible to leverage the fact that implied volatility is much greater than realized volatility even in an IRA by selling far OOTM covered calls on SPY. However, upon first glance it appears premiums on SPY are much lower than the premiums on SPX. To get near a $10 premium on SPY on 0DTE near market open it appears your call must be only around 0.5% OOTM rather than the 1.5-2% I’m used to seeing on SPX. Any idea why? Have you considered expanding your call-selling strategy into retirement accounts? Any concerns with doing so?
Did you make sure you scaled this properly? SPY trades ~570 and the index at 5,700. You’d need to sell about 10x the number of SPY calls to get the same notional exposure as the SPX. It would also create 10x the income in $.
Nope. That was my issue. Might optimistically be able to get around a $2 premium per ~$57k at a .01 delta on a 0DTE call. Might provide a few thousand dollars in income per year with the size of my IRA, then again, I wonder if it just makes sense to instead focus on being more broadly diversified in the IRA than cranking out call income using SPY. The strategy has looked more appealing using leverage in my IBKR brokerage account than in my IRA. I just have a decent chunk of funds in my IRA and figured that’s an opportunity to expand the strategy. I’ll probably still experiment with it in my IRA and perhaps try out SLIGHTLY higher premiums.
I monitored the situation this morning around market open.
SPY 570
SPY 0DTE 0.012 Delta calls at 0.01/0.02 B/A
SPX 5718
SPX 0DTE 0.013 Delta calls at 0.15/0.20 B/A
That pricing seems consistent to me. I also checked along higher Deltas.
Maybe you checked the prices outside of SPY trading hours?
Thanks for monitoring. I agree, I just didn’t scale it 10x originally. I think I’m going to move my IRA to Webull (commission free and giving 3.5% bonus on transfers right now) and sell covered calls on SPY to squeeze a little extra income out of the strategy. I don’t love that these commission free brokers take Payment for Order Flow, but hopefully the per-contract impact is lower than a commission would be. I imagine the PFOF impact will be a bit lower for SPY options given how liquid they are.
Good, Thanks for confirming. Glad we’re on the same page! 🙂
I’m a buy and hold index guy learning more about options, thanks to your posts. This is expanding my horizon – Thank you!
If OptionSellers wasn’t as leveraged, and their margin account held enough to cover a drop in value, would they have ridden it out to a profit? Before I start selling puts (following your conservative style), I’m trying to learn as much as possible about risks, and mitigating them.
Would holding European style options instead of American prevent this, if they’re only excercised when they expire? Or is that Mark to Market daily as well?
There are so many tiny details in derivative trading that I’m very nervous to start dipping my toes into it, due to fear of not understanding some bit and getting burned!
Correct. Optionsellers could have made the whole premium if they hadn’t been forced to liquidate along the way.
European vs. American made no difference. The margin calls would come either way. It’s mark-to-market, not the early exercise. 🙂
Hello ERN. May I ask how does this strategy compares to the equivelent of selling calls instead of puts?
2 advantages of selling calls instead of puts that I can think of are:
1. Out of the blue, single day spike of several % probably happens less often than a drop.
2. When you suffer losses on the option trading, at least your underlying portfolio gains on the same day.
What would be the disadvantages? Is it simply just less profitable?
I don’t find the overnight 1DTE call premiums rewarding enough. They are much lower than the put premiums.
But I do the 0DTE calls. And you’re right: If I lose money on those, at least I participate when stocks rally.
You mentioned having some cash in Fidelity and I’m wondering if you’ve ever considered implementing your options strategy using Fidelity instead of IBKR? I’ve come to understand they’re able to avoid the CBOE fee on SPX options and simply charge their options contract fee and the options clearing house fee for a total of about $0.68 fee per contract.
I know IBKR provides account access in a way that lets your friend trade on your behalf when you’re traveling, and that alone is probably reason to stay with IBKR. But I’m wondering if you see any other downsides with using Fidelity? I might be able to save a few thousand dollars in fees every year if Fidelity really only charges $0.68 per contract.
I’ve never tried it with Fidelity. But for folks with fewer constraints it should be a good route.
If you go that route, I’d be interested if Fidelity allows you to do aggressive margin trading the way IB does. I’ve heard some not-so-good feedback about the box spread trading at Fidelity. Maybe that carries over to the naked puts/calls as well.
I’m going to get started here and currently have all my investment assets at Fidelity so would prefer to do my options trading there as well.
Jeremy, did you go that direction or did you go with IBKR as well?
ERN, I don’t understand what you mean by the “fewer constraints” comment above. What are the constraints that are pushing you towards IBKR beyond the worries about being shut down due to aggressive/naked trades and box spread trading?
I went with IBKR and never ended up looking into Fidelity. I was worried, like ERN suggested, that Fidelity might not let me sell as many contracts on margin. I’d be interested in hearing how many overnight 1DTE puts, same-day 0DTE puts, and same-day 0DTE calls you’re able to sell on Fidelity with a given balance.
As for “fewer constraints,” I assumed ERN was referrencing my note that IBKR allows a friend to trade on your behalf (during his travel constraint) and I don’t believe Fidelity allows the same account setup.
I’ll dig into what limitations/guardrails Fidelity will put on my options trading. As an FYI, giving someone else with a Fidelity account access to your account is very easy. They offer about six different levels of access. I have “full access” to my wife and in-laws accounts. That means that from my account I can see their positions and execute trades.
If they’re options trading constraints aren’t too narrow for the strategy, I think the only remaining concern was the potential for getting shut out on a very high volume day. ERN, is this concern speculative or something that has been a problem in the past?
I use Fidelity for some of my other accounts. I like them. I wouldn’t trust them to satisfy the trading needs I currently have on the options side.
ERN, I hate to ask since you already do so much but can I ask you for a few more details on the requirements you don’t think Fidelity will be able to meet so I can do the investigation? It will be painful to split my assets and would like to avoid if I can but I’m serious about getting started with your options trading strategy and don’t want to get stuck.
Is there exotic trade types you think might be missing? Higher margin requirements? Lack of data in the dashboard? Restricted access during high volume periods?
To me the only shortcoming is that Fidelity doesn’t have the advisor setup. I need my friend to have access to my account (but not have full access) while I’m traveling.
If that’s not a concern, you probably should try Fidelity first. If you see it doesn’t work out, you can always easily transfer your asset to IB via ACATS.
Correct! Thanks for explaining it before I got to reply.
IB offers to do the adviser setup where I can trade my friends’ accounts and vice versa.
Hi Karsten!
Thanks for the great work that you do. I have benefitted significantly in educating myself. I have a few basic questions if you don’t mind:
1. I do not have sufficient capital (or confidence right now) to trade with SPX. What would you recommend for replicating this strategy but with smaller exposure? I read that SPY is an option but it is American-style and subject to short-term capital gains taxes. I came across XSP and MES futures that are both subject to favorable Section 1256 taxation and are European-style but might suffer from liquidity problems.
2. In Part 2 of your options post, you mention that you used to trade ES futures options due to “We can run a tighter ship with our margin cash.” But in Part 3, you mention switching to SPX options due to “Better margin efficiency”. I am a bit confused. Are the margin requirements identical for the two as you mention in Part 3 and the only difference is the IBKR handling? Can you please clarify the change in position?
3. As I understand, you are selling naked puts backed by a collateral of 40-50% of your put exposure. Is that correct? If yes, can you please explain what happens if you get assigned? I read that you maintain about 5% cash in margin account for such incident. But if the losses are greater than that (which they easily can be), does IBKR sell one of your bonds automatically or do you get a margin call (resulting in interest on borrowed money)?
1: As a training exercise, the XSP might work, but the commissions will eat up most of your profits. Otherwise, wait until you have at least ~$120k-150k of capital before trading.
2: “tighter ship” means I prefer the ES over the SPY-ETF options. But I still prefer the SPX options over the ES contracts. That has to do with the margin cash separated into “US Securities” vs. “US Commodities”
I also had another constraint while sill working at BNY Mellon: I was allowed to trade ES futures options, but not the SPX index options. After retiring I transitioned over to the SPX index options.
3: I am selling naked puts. I don’t know what the phrase ” backed by a collateral of 40-50% of your put exposure” means but that’s irrelevant to the answer.
“I read that you maintain about 5% cash in margin account” -> correct
“But if the losses are greater than that (which they easily can be), does IBKR sell one of your bonds automatically or do you get a margin call (resulting in interest on borrowed money)?” -> no. First, it has never happened. It never even came close to it. If it did, you’d merely have a negative cash balance.
Thanks for the response! I am still a bit confused about the margin part of it. Let me use numbers to clarify:
As of today, SPX is ~5,800. Let’s say I sell a naked put contract that expires tomorrow at a strike price of ~5,700 for $100 in premium. That would be an exposure of $5,70,000. As per your posts, to maintain 2x-2.5x leverage, I would need to have 40-50% of $5,70,000 in my Portfolio Margin (PM) account (this is what I meant). That is about $2,85,000 in the PM account. Is that correct?
Assuming that the above is right, I would then have about 5% of the PM account value in cash. So, I have $14,250 sitting as cash and the remaining amount invested in bonds, preferred shares etc. If that is correct, won’t a more than ~243 point drop in the index (-4.2%, to 5557) result in my cash + premium getting wiped out? Are you saying that such a drop has never happened for you? Or is it that the premium offsets for the drop more than I have accounted for in my example? Massive drops such as those that happened during COVID should burn your cash cushion pretty quickly. Trying to wrap my head around how that has never happened!
One more question – for the money in the PM account, I read in Part 3 that you invest in a combination of bonds, preferred shares etc. Is that primarily to decrease your correlation with SP500 (since your option trade is long SP500)? Are there any other reasons such as better margin assessment in your PM account, tax benefits etc.? Can you please guide me a little on what to invest the PM money in? Are your positions similar to the ones mentioned in Part 3?
Let’s work with my numbers.
I currently designate about $165,000 in capital per short put. Most puts I write have strikes around 5500-5600 lately. SPX trading at 5800.
The notional exposure of one contract is 555,000 assuming the midpoint of the 5500-5600 range. That’s about 30% of coverage or 3.3x leverage.
I keep about $7,000 in cash per contract. So, I have $7,000 in cash and $158,000 in other assets in the account.
If the market were to drop to 5550-70=5480 points I’d have a loss of $7,000 and wipe out my cash. But not my other assets. That would take a drop by another 1580 points – highly unlikely in one day.
About the pandemic months: I sold puts with strikes much further out of the money. Sometimes 20-25% out of the money. So, please re-read my section on the volatility clusters, i.e., large drops happening when VIX (implied vol) are already high.
Hello Karsten,
Do you maintain $7,000 in cash per contract in your IBKR cash account, or do you keep it in another liquid fund to earn higher interest?
It’s in cash.
Hello Karsten,
Newbie here. Thanks for your great post. The last line “But I d” of the last section “Are there ETFs worth considering?” seems incomplete. What did you want to say there?
Thanks for letting me know. That sentence got chopped off. I corrected that!
Curious to hear what kinds of premiums you target in low and high implied volatility environments, both of which we’ve experienced over the course of the past week. At market close on election day, I sold $0.65 premiums at 5200 strike because they were 10% OOTM and that seemed safe enough. Curious if you go closer ITM for more premium or stay further out as “safe with good enough” premium. Also curious regarding the last couple of days at market close. You couldn’t get to a $0.10 premium without being less than ~3-4% OOTM whereas there were some $0.05 premiums all the way down to ~5250 strike, which is what I sold. Do you feel safe enough taking $0.10 premiums in low IV environments or do you take what looks like a much better strike price for the premium at $0.05?
Amazing! I sold puts for 0.65-0.75 on Nov 5. I did 0.10 over the last few days. Not much premium out there, but after an amazing start to the month, I’m willing to slow down a little bit. But I’ve done 0.05 a few times as well. Very rarely, though.
Hello ERN.
Based on your experience and particularly recent experience with stop-loss orders I have a question:
If, for every put option I sell at price X, I also place a stop-loss order at 5X (equivalent to one week of premiums), would such a strategy be profitable? Or would the stop-loss orders, on average, be triggered one or more times per week?
If it remains profitable, what do you think would be the optimal value of X to maximize profits?
For example, in the $0.1-$0.5 combo, the stop-loss orders are likely triggered the least, but the gross profit is also the lowest.
What about other combinations still in the far out-of-the-money range, such as $0.5-$2.5 or $1-$5?
I realize you’re asking ERN but anecdotally I’ve been using 4X and it’s not great but seems to be OK. For example today it triggered making me feel like it was too sensitive. Overall with my small sample size, it’s working. In theory you don’t really need stop loss if your expected overall returns are positive as I understand ERNs concept.
I think stop loss probably isn’t a sure-fire risk reduction strategy but it might give some peace-of-mind. I’m tempted to either forgo it or use a higher value like 10X if only to make me feel better about a potential black swan event.
The strategy is profitable if the STP is executed with low enough probability.
I have no fixed value for X but I usually set it to something a little bit higher than 5. Maybe 10-20.
I have been backtesting this strategy on the Indian market index (NIFTY50). I backtested replicating your strategy for different deltas (-0.01 to -1, with an interval of -0.01). Interestingly, I found that -0.8 to -0.7 delta options actually had the highest payoff. I am surprised but curious if you ever backtested or tried writing in-the-money puts. Intuitively, although these would provide negligible cushion against drops in the market, they would lead to higher premium pocketed when the market rises (which it does more often than not).
Numerically, if the underlying is at 100, -0.05 delta at 90 and -0.75 delta at 110 with both having the same time value of $2, then you are protected until 88 with -0.05 delta but only until 98 with the -0.75 delta. But, when the underlying rises to 100 + x, you pocket an additional $x (upto $10) for the -0.75 delta but nothing for -0.05 delta. Wondering if there is a basic flaw in this reasoning.
I’m not interested in the highest payout. I’m interested in the highest Information Ratio (IR) and then scale up the leverage accordingly.
Hello Karsten,
I recall reading in one of your previous posts that you place your daily stop-loss orders each morning at market open. I see how this can protect against potential excessive losses on your 0DTE puts if there is a big intraday market downturn. However, I’m not sure I understand how this stop-loss strategy will provide protection against a “Black Swan” type event for the 1DTE puts placed at the end of the previous trading day.
How does your stop-loss strategy work if a huge overnight or weekend gap-down “Black Swan” event occurs in which the market opens the next trading day way down (and the 1DTE options are already in-the-money or close to being in-the-money)?
It doesn’t provide protection against all Black Swan events. Certainly not against a big drop overnight. But Black Monday in 1987 was a slow meltdown on that day not overnight. A STP would have been helpful.
On Monday August 5 this year, the market opened with all short puts well above my usual STP level. But they were sill out-of-the-money. So, I just sat it out and it was the correct decision.
Do you set your 1 DTE stop orders to be good until cancel (so they run overnight and through the next day) or just place them for the same day only. it sounds like on August 5th 2024, you didn’t have a stop order in place at the market open so you could still make a decision about what to do? what do you recommend?
STPs would execute overnight during the off-hours. There might an option to override that but I don’t recommend that due to low liquidity.
I have on very rare occasions closed trades manually before the open when things got too dicey. But on August 5 2024 I just rode it out because I thought that the central bank action in Japan didn’t warrant a significant drop in the US that would threaten my strikes that day.
Hi Karsten, I’ve been intrigued by your particular options strategy for some time but have been wondering about an ETF since I’m not able to trade frequently (due to my day job). I saw your reference to PUTW, but I recently learned about ISPY (not to be confused with SPYI). It sounds similar in some aspects but is a daily covered call strategy using swap agreements. Unless I’m mistaken, it appears it could be tax efficient due to a large portion of the returns being a return of capital. Not sure about 1256 tax treatment. It seems fairly new. Would love to know your thoughts on this sometime as a surrogate of sorts to your strategy. I search the comments but could not find anything. Here’s a link if helpful (https://www.proshares.com/our-etfs/strategic/ispy). Thank you as always!
I don’t like it. It’s lagging way behind the S&P, but has almost the same volatility.
Hi Ern,
Thank you for your info. This is all way over my head at the moment. How can I learn more, starting with the basics first?
This is the starting point. Maybe look through the induvial posts for more detailed info?!
There is some info on youtube, but it gets “scammy” very quickly.
Hi,
Thank you for your blog about options.
I understand that implied volatility is more than actual volatility.
Say when we sell a put option that costs 20 cents. the bid ask spread is usually 5 cents. That is about 25%
I believe that the purchaser of the option is a market maker not a retail trader.
With 25% margin in bid ask spread, I dont think there is 25% difference in implied vs actual volatility. So essentially we may be underpaid for the risk taken by selling the put option, especially when we have to cross the bid ask spread as we are short on time to have our trade filled, say in last 3 minutes of trading hours each day as we dont want to spend too much time doing this.
Have you done any math/research w.r.t. bid ask spread and how much we are underpaid due to this ?
Thank you
I think there’s a major misunderstanding here:
Take this example: I sell a put at $0.25 limit when the B/A was $0.20/0.30. I calculate an IV of 40%. The subsequent realized volatility was only 25%. So, I have sold an option that had a higher IV than the realized. If I do this every day I make money.
Are you saying that you now want to reduce my IV calculation by 40% ($0.10 cent B/A spread divided by $0.25 premium), i.e., (40 minus 16)% = 24?? But that’s not right. I already calculate the IV at the midpoint where I place the limit order and my order fills. Even if I were a bad (i.e., impatient) trader and I consistently sell at $0.20, that’s only 20% below the true option value not the entire B/A spread percentage.
Thank you ERN for taking time to reply. Yes, you got the question right.
I am selling $0.05 valued options. They have bid of $0.05 and ask of $0.10
Most of the time I have to cross the spread as I want to rush it out in last few minutes and be done. Here I am selling 50% below the mid point of B/A. (0.075-0.05)/0.05*100=50%
I guess, I have to pick options with tighter B/A spread in percentage, those are always with strikes relatively closer to current SPX than the ones with B$0.05/A$0.10 valued options. If I have to pick even B$0.20/A$0.25 values options that would be around 300 points of strike closer to SPX and reducing the wiggle room making me uncomfortable.
Can you please think of strategies for people who are only interested in selling only the Deepest out of the money options ? OR for these people, it is better of not use this strategy due to infeasible capture of right amount of premium.
Thanks again.
But even if you sell the 0.05 option at that Ask, you normally get an IV that’s astronomically higher than the average realized vol in the last few days. Hence, you make money.
So, my strategy works for you as well (or even better) as mine.
Hi Karsten,
First off let me say I really enjoy your articles and apricate all the work you put in. I think you have an amazing mind for finance and certainly are very strong at math and statistics. I am new to options and perhaps I am misunderstanding some key concepts here but can you help me understand where I am off track please? Reading your 2023 update “Most of the overnight puts only fetched a $0.10 premium” and it seems your capital commitment is around 135k per contract and your daily time commit is ~10 minutes at open and ~10 minutes at close daily. Your premium capture is north of 90%. I understand that your capital is invested and is returning an nice 4%-6% beyond the option selling strategy. If we put that piece aside and look at the return on the strategy am I to believe that per contract your getting $10 and keeping $9 before trading costs and taxes? At those capital levels I would likely only be able to buy 1-2 contract at a time. I really enjoy following the market but if the basic idea is I need to be spending 10 minutes watching markets pretty tight every open and close almost every day and taking actions for a likely $9 pretax/pre-trading fee profit it would not make much sense. I am not sure how to tell the family we can’t go do something at 3:30 every day because I need to watch my $9 profit and make sure I don’t lose it? I also think starting out it is fair to say we don’t have your secret sauce and are just simply not as good at executing on the strategy as somebody with your level of expertise is. That could mean if you make $9/day/contract rookies may be better to plan for $5/contract/day. Please help me understand what I got wrong here. Thanks!
Then do it only when you have time and it’s fun for you. Remember, you keep the rest of the portfolio. All the options stuff is extra profit!
But with a $2m+ portfolio with supplemental trades using 0DTE puts and calls, together with the 1DTE puts you can make an extra $80k a year.
For large enough accounts, it would also be feasible to outsource the trading to a registered financial adviser (in exchange for a small fee, of course).
Big ERN, Have you ever thought of starting a fund that exactly replicates your strategy? (I know I would buy in!). If this is even possible, would that take the fun away for you? 🙂
Not a fund, at least not yet. But I would consider doing separately-managed accounts for paying clients. See my most recent post. It wouldn’t take the fun away. 🙂
Cool post!
Specifically for IBKR, do you get hit with the “Exposure Fee” they charge? A decade ago it wasn’t so bad, but they seem to have recently toggled the fee to trigger earlier and for a more obnoxious amount compared to in the past, especially on ES and NQ underlyings. Although other brokerages don’t have it, those seem to require more margin against naked futures options. Have you looked into optimizing this, or is the exposure fee a cost of doing business?
I usually set my 1DTE puts so that I just barely avoid it. Or sometimes get hit with a $1.07 exposure fee. But it’s annoying, I agree.
Exceptions would be very profitable days where I make huge profits and even if I lose 10% of those due to an E.F. it’s still worthwhile. But I try to avoid the fee most days!
Thanks for the quick reply. I’ve written to their support staff a few times about the issue. As they mention on their explanation website (which always has outdated pages), the exposure fee calculation simulates a one day 30% drop in S&P to determine whether your account would go negative on such a drop. Of course, we’re rolling our eyes saying even the 1987 crash wasn’t that bad, but that’s a separate issue.
The trick seems to be picking 1256 contracts that are not fully correlated with S&P. By definition, SPX and ES contracts get the full brunt of the simulated -30% one day drop. They have NQ correlated enough that it is also not a great option. Have you looked at trying the 1 DTE strat on anything else beyond SPX / ES? CL and GC might avoid the exposure fees, but they don’t have the 1 DTE every day, it’s only 3 times a week, which still might work for your strategy.
Yes, that’s the exposure fee calculation. -30% SPX. But even -50% for individual stocks. All relevant equity and other futures are either -30% or worse. There’s no escaping that fee. I simply size my bets to account for this and avoid the fee most of the time.
https://www.ibkrguides.com/kb/article-3114.htm
hi ERN, thank you so much for sharing your knowledge on this strategy. I have read a lot of your articles and listened to your podcast appearances. I have just started to paper trade this on IKBR and would I like to clarify the following before going live:
1) You mentioned in the one of comments above you maintain assets of $135k as collateral to back each contract. Can you sell both a deep OTM call and put 0DTE using the same above margin, as both cannot be triggered. I have noticed the margin requirements on IKBR barely increase when selling calls after puts and vice versa.
2) Do you use $135k versus the IKBR minimum of $55k to avoid being margin called or if IKBR suddenly raises their minimum margin?
3) Is it possible to apply this strategy to other uncorrelated markets simultaneously to obtain additional diversification, over and above the time diversification from 0 and 1 DTE SPX options.
Thanks
All great questions:
1: Yes, with portfolio margin, you can sell both on the call and put side and your margin assets can do double-duty, so to say.
2: Correct. I currently use about $165k per short put overnight. $60k is the initial margin, but I keep much more than that, jut to be sure.
3: Yes! I’m debating if I should branch out into other indices. So far, the SPX works great, but I know other people doing the same with a whole list of underlying assets: commodities and bonds as well.
How did you decide on keeping $165k margin per short? I understand the part about IBKR wanting $60k per short. That allows IBKR to stay whole even the put ends up 600 points in the money, seems reasonable and not likely to happen very often. Do you know how IBKR’s margin requirement changes as SPX changes? Say for a 1 DTE option, the following morning SPX opened at exactly the put’s strike, what would the margin requirement be at that point? If it was dramatically more than 60k and you didn’t have it, would they sell a big chunk of your assets until you met the requirements? Would they force you to buy back the put?
The margin requirement would go up if the market falls substantially. That’s why you want to leave plenty of room, especially for the 1DTE puts.
If I want to keep a lower amount of margin per short than the 165k you suggested, could I instead just sell a put credit spreads? IBKR has a much lower requirement for put credit spreads (I estimated it at around 10k for a 400 point spread with a 0.2 credit and 0.05 debit), but in these cases would you still want to have the 165k or would a much lower amount be acceptable?
Yes. Margin is much relaxed when you go from naked to credit spreads. If it’s a 400pt spread, you’ll need 400x$100=$40,000 in margin, and likely less. Check at IB what the initial would be!
Yes IBKR relaxes margin requirements a lot when I do spreads! Given that, how do you feel about selling many spreads in place of a single put to increase total daily income? I’d still use STPs to protect against big losses.
For 0DTE, I’d max out the margin. For 1DTE. I tread more cautiously.
hello!
Fantastic article and content!
I’m interested in implementing selling Naked puts and Calls on SPX and wanted to ask if you shed some clarity on the margin requirements.
Do we need Portfolio Margin?
How approximately is held per contract?
What account size should we have to ensure there is a buffer?
Thank you!
You need portfolio margin.
I hold my capital in preferred shares and Fidelity index mutual funds.
I have about $165k per short overnight put. I’d target at least a $500k minimum account size.
Any recommended books or sites to learn options basics? Thanks
I like the Whaley book as a reference manual (with Excel add-in toolkit for options pricing formulas).
https://www.amazon.com/gp/product/0471786322/ref=as_li_tl?ie=UTF8&camp=1789&creative=9325&creativeASIN=0471786322&linkCode=as2&tag=earlyretir007-20&linkId=d7648fb59b4ec09774e9acf87c32adb8
I’m the only one doing this particular strategy, so I don’t recommend any sites in particular. But for general options trading content, Tasty Trade is a trusted source.
Hi ERN! Im a huge fan. Thanks for sharing your valuable insights. Im a newbie to options trading – ive bought leaps , hoping to get benefit of leverage.
Ive 30k as cash that i want to run your put option stragegy on XSP. Im struggling to figure out if IKBR would allow this, or do i need $110k minimum for portfolio margin?
Moreover, given current volatility, im taking a conservative approach of strike price at -5% of current levels, but i see 0 volume & open interest. Do you run into volume issues on SPX? I thought with elevated VIX, i should be able to get some volume.
Do you trade at a higher strike price? What is the model for finding strike price?
TIA!
Without portfolio margin, I wouldn’t recommend this strategy.
It also wouldn’t make much sense trying to squeeze am additional 4% return out of $30k. That’s $1200 p.a. Too little for daily trading.
5% out of the money is very lucrative right now for 1DTE. Even 0DTE puts 250 pts OTM would fetch around $0.10-0.15 premium. Not bad. So maybe there isn’t very much activity in the XSPs.
thanks ERN!
I started trading XSP to dip my feet in the water. I was very happy to be able to ride the wave when market was going down with rising premiums. Had a couple of questions-
1. How do you set your strike price -> ive been looking at Delt & VIX. Do you have a model to predict strike price given these inputs? are there any addl inputs you work with?
2. Computing Leverage -> For 0/1 DTE, we dont expect a complete wipeout, as stock market has circuit breakers. Even during “sudden black swans” 9/11, trading was halted. So is it reasonable to assume the worst case as a proportion of the theoretical total loss; ie 1-(1-0.2)^2 36% ? THis dramatically increases the amount that one can invest, your thoughts? what potential problems do you see with this approach?
TIA!
I check the premium and the % OTM and find whatever I like that day. There is no fixed rule.
Your leverage is constrained by exchange margin rules and the OB exposure fee.
36% is a lot. There is no premium for 36% OTM puts, not even right now with elevated volatility.
to clarify – what i meant was the following:
Suppose SPX is at 5500. Max loss is 550,000. So if you have 165,000 per put option, leverage is 3.3x
My point being – is max loss really 550,000, or is it 352,000 (20% losses for 2 days). With 352,000 the leverage becomes 2.13? So if one is comfortable with 3x leverage, they should sell sell more options. Do you see any issues with this line of thinking?
IB’s margin rules are pretty relaxed- i have reg T & IB allows me to sell 4 XSP put options with 30k assets
My definition of leverage is max exposure divided by capital. 3.3x in that case.
Your definition is something else. I wouldn’t use that leverage.
“There is no fixed rule”. After two years of all reading all posts, including the whole SWR series, I’m fairly surprised by this. Part of what makes your content so compelling is the incredible amount of technical analysis you’ve done on every decision point you consider. At the end there’s always a conclusion of the best path, even if the difference is marginal. In one of your SWR postings, you even called out the need for precision in decision making and execution of plan.
This is not at all a critique. It obviously works for you and I am super appreciative of all the detailed information you have provided. It does make me a bit tentative to get started since there’s Karsten magic sauce that I will need to learn by trial and error. It also leaves room for emotion to creep in. I would love to train an AI model based on your history of trades, the market conditions (i.e. current VIX), and the resulting outcome. It would be fun to start comparing its predictions to your actual trades and thus whether it can start to understand your special sauce.
Jason
Yeah, that would be nice to have an AI bot do what I would do. At this point, I would not trust AI enough to completely let go of my control though.
This also blows me away — there is no fixed rule? There seems like a lot of intuition and consideration involved in determining the tradeoff between delta, premium, and sizing. Eg, right now I buy a single 5 delta put for $1 or I can buy 10 0.3 delta puts for $1. These two trades have hugely different risk profiles even though the return is identical.
Sorry, *sell* not buy.
noted
I never said that my strategy is as ambiguous as the wide range in your example, with obviously dramatically different P/L profiles. My trading is much narrower than that. But there is no “fixed rule”
For everyone obsessed with “fixed rules,” you shouldn’t trade options. Do the Bogleheads/JL Collins index fund investing. You don’t understand this market enough to trade derivatives.
I guess I’m surprised given the content of your posts that there hasn’t been much discussion fleshing out which otm puts you feel gives the best balance of risk vs. reward. Perhaps an idea for another post!
The process of deciding where the attractive premium puts strikes are is something that you decide every time. There is no fixed formula. Even if I had a formula, I wouldn’t publish it for fear of folks front-running my trades.
Can you update us on how this strategy performed during this correction?
The 0DTE/1DTE are up. Unfortunately, the longer-dated puts and vertical spreads are down, but only temporarily. I don’t think we’ll fall to 2000 points by June, so I will likely recover those losses.
Did anything end up in the money? Especially on the worst days when SPX dropped 300+ points. Did you sell calls the day before SPX jumped around 10%? If you took losses, did you recover by now?
The 10% jump in April happened during trading hours, so I believe that in the worse case, he had some stop orders triggered on those calls and ended up with small losses – just like I did.
Correct. STPs worked as planned, even during the crazy 10% rally on 4/9.
Yes. I had a few puts and calls in the week of 4/7-4/11 that went in the money. It’s the way the business works occasionally. I’ve long since recovered the losses. April was still a slightly net positive month. My last monthly loss was June 2022.
Hi ERN,
This whole thing feels like just providing liquidity or balance sheet lending. By any chance did you compare your strategy with just simply leveraged buy of SPY say 130% of SPY ETF.
Both option selling and levered SPY have correlated draw downs. I expect them to have similar returns over a longer period of time say 2 to 5 years.
That’s a very different strategy. 130% leverage on SPY would be way too risky in retirement.
My option selling DOES NOT correlate much on the downside. My best month ever was March 2020.
Hi ERN, Thank you for answering.
Yes in the broad sense they are not correlate, except in the initial drawdowns.
Pasting your words:
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.
So correlation exist only in the inital phase(first few days) of the bear market and then they dont correlate.
We have to have enough margin to tide through the initial phase and not count on the options-non correlation to save us as the non-correlation happens only after the initial correlation.
Thank you for helping me see how they are not-correlated atleast after the initial phase.
Am I understanding it right ?
Yeas, that’s paraphrasing what I wrote.
I won’t say that there is never any more correlation after the first few days of the bear started, but you hope that the volatility builds up slowly enough that you always sell puts far enough out of the money.
Selling further out of the money means smaller premiums so you need leverage or portfolio margin. Without that capability, does this strategy work with put selling that is closer to the money or even at the money? This means bigger premiums but of course you’re much more likely to suffer a loss when it goes in the money, but could you still do well if you have a large number of sales in a year?
I have historically sold closer to the money. It should work, too. But with the tradeoff you mention.
Hello ERN, thanks for all the information passed. I’ve been doing your strategy with great success, focusing on relatively safe premiums of 0,10 cents 99% of the time of and it has been grateful to do not care about the SWR because there is an income flow from the Option trading. I want to express my deep gratitude for you and your free knowledge transmitted online, It changed my life and the life of my family down here in Brazil =)
I have a question for you:
I was questioning myself about the growth of the income with the strategy. If I don’t save any money that I make with your strategy even if the portfolio keeps growing(with is natural if I don’t sell any ETF and just using the income from the strategy) it will be the same amount forever right?
Because even with the portfolio growth, the strikes of the options will grow as well at the same speed so the margin requirements and all the rest. So I will be always selling the same amount of contracts at the same 0,10 forever unless I keep some cash and reinvest buying more ETFs, right?
If you target a fixed 0.10 fee, correct, your income will stagnate. But with the market growing, eventually the equivalent of a 0.10 premium will than become a 0.15 premium, then 0.20, and so on.
Or, alternatively, you keep the premium at 0.10, but the options are going further and further out of the money, so they become safer. You may slowly increase the leverage (number of contracts) and grow the income that way.
Hey ERN!
A couple questions about how you’re using IBKR
1) Exposure fee
Per a comment you made somewhere (maybe it was TwoSidesOfFI podcast) I believe I heard you say that you trade as many 1DTEs as you can WITHOUT an exposure fee. Then you use rest of margin the following day with 0DTEs.
Is that true? Or are you willing to pay a certain threshold of exposure fees?
How are you determining what exposure fees you’re exposed to at the moment?
I’m trying to follow that pattern (1DTE between the 4:00-4:15 after market window) but I’m a little confused at how IBKR calculates the exposure fee because from what I understand it’s only supposed to apply for overnight positions. Yet I’ll see the exposure fee # go up in my Trade window preview for TWS even if it’s just for 0DTEs. Then at around 4:05pm EST I try to put on some 1DTEs in the brief ‘after hours’ trading window for SPX but the exposure fee calculator in my trade preview makes it look like it’s adding more exposure fee ON TOP of the trades that are already expiring that day (which I would THINK it would know I’m not exposed to anymore since they should have synthetically expired by 4pm EST now).
2) Margin Limit
Similar Q to the exposure fee but in that brief 15 minute window I’m about to put on more 1DTE trades but it doesn’t look like my margin is ‘freed up’ yet to make more (I’m using the TWS desktop tool)
I believe I heard you say something about IBKR letting you ‘temporarily doubling up’ during that window.
Can you give me an example of how you’re doing this “double up” thing safely or what numbers/tools/ or rules of thumbs you’re doing to make sure not gonna cause a margin call on yourself?
I’m not seeing my margin free up even when all my options are expiring that day and the market just ‘closed’ already for those options and hypothetically they should be expired so my margin should have freed up by then.
If the premium is high enough, I will certainly pay a small exposure fee. But under normal conditions, when the premium is only 0.10 or 0.15, I try to avoid it.
The 0DTE should not impact your exposure fee. I think the IBKR calculator is wrong there.
If you’re using portfolio margin, your margin should come back at around 10-60 seconds after the NYSE market close at the top of the hour.
IBKR does not let you double-up on risk. The contracts expire at the top of the hour. So, you can now use the freed up margin to trade the new 1DTE contracts. As I wrote before, it takes about 10-60 seconds for that when using portfolio margin. Reg T margin will not work.
Hi ERN
With SPX options trading at 0.05 increments, do you have any strategies for getting the best price execution? For example, do you try sell puts at strikes where the bid at the next lower strike is 0.05 lower to try to get the best price and furthest out of the money? Do you try to get a better price than the bid by selling at the midpoint between bid/ask (if the spread is 0.1 or more)? Do you try to set a limit order higher than the bid or even the ask and hope the market fluctuates enough to hit it?
I’ve seen some cases where the price of a put will go up even if the market is stable or trending up during the day. Or sometimes a little bit of a drop in SPX during the day (like 0.3%) is enough result in a big jump in an out of the money put (from say $0.1 to $0.25). Is there a time of day where you are more likely to get a better price? This can be a way to make quite a bit more on premiums as you’ll see put option prices go up even 50%-100% more as time is passing by.
1: See the screenshot below. You could sell a 0.15 put with a 5970 strike, that’s the lowest strike with a 0.15 bid. You also see that the 5900 strike is the highest strike with a 0.15 ask, currently sitting there, so nobody is currently buying there. Anywhere between 5905 and 5965 you could split the 0.10-0.20 B/A range and submit a limit 0.15 sell order. Your order would be the first to be filled. Where you want to place it is up to you. The higher the strike the faster the fill.
2: Yes, sometimes the market doesn’t move and the strikes/premium still works against you. Probably implied volatility went up.
I don’t wanna be the Debbie Downer, but I suspect this strategy would have obliterated your account during the 2010 Flash Crash, when the market dropped 9% in minutes. AFAIK it was the most violent drop in modern stock market history when measured by rate of change. At the time, I was at the computer trading options, and it was pandemonium. Nothing was normal. Option spreads were insane. There’s a risk of IB auto-liquidating your account under these circumstances, and I’m not sure what price you’d receive with a market order with option spreads that wide.
Since it happened during trading hours, stop-loss orders are supposed to help get rid of positions before anyone, including algos, even realizes we’re in a flash crash situation.
SPX options are liquid, with market makers willing to close your position, so if you set a stop low enough, it happens in a matter of milliseconds before spreads are becoming insane.
While not the same, in April the market moved 10% in a single day, and I think about 5% of it happened instantly when Trump announced the tariff postponement.
The stops worked wonderfully well in that scenario.
Yup, same for me. The STPs worked exactly as designed.
The 2010 flash crash was -7% in 15 minutes. The top-to-bottom -9% move was much longer. I wouldn’t call this “in minutes”
In any case, use Stop Loss orders. It worked on April 9 when the market rallied by 10% within a short period of time.
You estimate the VIX to be about 36 the day before the October 1987 one day crash of 20+%. The VIX was around those levels in April and a look at put prices shows that you would have been in the money after a 20% crash. Take April 9th, VIX closed at 33.62 and SPX at 5456 The lowest strike put that still had a bid at the close was 4630 at $0.05. If the market fell 20.5% the next day you would be at 4337 412 points in the money!
So a 1987 crash could be a near wipe out scenario. Stop losses are a must, but not sure if you’d get a good execution price with the craziness thats happening. Have you given any more thought to 1987?
The 0.05 premium would not have been at 4630. Who told you that stat? I shorted puts that day in the last 30 minutes of trading at strikes 4600-4750, weighted average 4681. With premium between 0.60 and 1.10. Implied Vol around 100%, yes, 3x the IV in the VIX. There is no way the 0.05 bid was at 4630.
To use the 1987 scenario, yes, I’ve given it a lot of thought. Clearly more thought than you have: my strikes were 13-16% out of the money. Oct 19, 1987 started only slightly down and the meltdown to -21% was gradual. If you had short puts 13-16% OTM you would have eventually hit your STPs. So, I wouldn’t lose 412 points, I would lose my regular overnight STP target.
Besides, 4630-4337=293, not 412. Please check your math.
Even in the craziest scenario, where someone had “forgotten” to put in the STPs, the S&P500 would have been about 6% ITM, which is not a wipeout, at least not at 3x leverage. Can’t you do the math yourself? Why do you call this a “near wipe out scenario”?
I got it from Schwab’s thinkorswim desktop app where you a use thinkBack to get a historical options data up to 6 months ago. Here’s some screenshots show all the puts from at the money, the close that day on April 9th was 5456 to the lowest bid at at 4630 for $0.05: https://postimg.cc/gallery/fXQnh4q The market just had the huge rally after the tariff postponement announcement so it makes sense to me not many puts were being bought at lower prices.
I don’t know what else to say. Could the data be wrong? It sure looks accurate, especially the crossover between OTM/ITM is at 5455 which matches the close of 5456 on April 9th and these are options to expire on April 10th.
I sold a 1dte 0.5$ put on 09.04 right after market close (5456 as you wrote) and the strike was 4760. There is no way 4630, which is just 130 points below was 0.05$.
Maybe the prices that you see are not from 09.04 market close but already from 10.04.
If the screenshot showed prices on 4/10, then the crossover point from OTM/ITM would not be 5455 since the market high that day was 5353
It doesn’t matter what the crossover point says. The numbers are wrong, and the correct cross-over point doesn’t fix that.
Do you have a plausible explanation for how Schwab can get that much options data that looks correct but majorly wrong? I don’t think someone was sitting at their spreadsheet and blatantly manipulating it
Data are not at market close. One giveaway: the “Last” is often way above the B/A range. So, the B/A must have been recorded way after the Last trade.
But again: I shut down this discussion now. You’re clearly not amenable to any reasonable discussion.
Agree. Thanks for confirming!
I think they are 9/4 but 4.25 hours after NYSE close when the options start trading again in the off-hours.
There are (at least) two reasons for this bad number:
1: the data on Schwab are indeed wrong. I traded a few minutes before the close: Strike 4700, premium 0.60, SPX index at the time 4568. You can’t tell me that the index went down from there and the premium evaporated from 0.60 to B=0.10, A=0.25. That’s impossible.
2: You don’t know how to read options quotes (or any quote for that matter). Nobody would sell at 4630 for 0.05when the ask is 0.20. You could do a limit order at 0.10 or 0.15 at 4630. Or even at 4550 and below (table is cut off before there) where you still had A=0, B=0.15, you could have easily gotten a 0.05 fill or even 0.10. But that’s really a red herring, see item #1.
So, that 4630 number is a totally ludicrous figure, even if the Schwab had been right (which they weren’t)
Lesson learned: Use Schwab for your ETFs and low-cost mutual funds. For options, you’d need a more professional provider.
Ok you’re right about 293. So at 293 points in the money, or a loss of 29k per put? If you had 165k in assets, you get roughly that much in margin correct? So you’d take a 29k loss on 165k in assets, after the market dropped 20.5% you have 165k – 20.5% – 29k = 102k. So the total loss after the 1 day 1987 style crash about 38%. I guess it’s recoverable. Seems like put generating income might go down 38% right away since you have a lot less available margin.
OK, for the folks with reading-comprehension disability, I write it once more:
My loss would have been about $800 per contract, assuming a $7.50 Stop Loss and a (generous) additional loss of $0.50 due to the STP and the market order filled at illiquid times. On October 19, the market melted down very gradually during the day and you had enough time to get out before going 293 points in the money. $800 per $165,000 capital is less than 0.5%.
Also, I don’t recommend using much more than 2x leverage when you have a 100% equity portfolio. So if you lose the 20.5% in a 100% equity portfolio, you would have lost a little less than 38%. But again: Nobody would sit on their hands on a day like 10/19/1987 without a STP.
I’m speaking to the case where you didn’t set a stop or monitor the markets in 1987. You’d end up in the money and lose 29k per put under those figures.
What kind of portfolio do you have a 3x leverage? 60/40 stocks/bonds?
That’s like saying, “if you drive 60mph and don’t break you’re going to hit a wall/go over the edge/fall into the water/etc., so let’s better never drive a car” But that’s a stupid “what if” scenario because I am using STPs. Your arguments so far rely on clearly faulty data and faulty logic. Thus, at this point, Joe, I am shutting down this line of discussion. I won’t try to convince you to trade this. Quite the opposite, I strongly recommend you to not trade options.
At the same time, you couldn’t dissuade any of us options traders either. We will just leave it at that.
I feel like theres been some miscommunication here and I’m sorry and am responsible for that. I actually think your strategy is quite sound and I’ve been doing it for a short time successfully. I understand the basics of how it works and understand that you’ve been using STPs. I had some debate in my head about using or not using stops and trying to figure out the worst possible loss without stops which led me to 1987. With STPs, you’ll have losses more frequently than without STPs. However, without STPs you have a risk of a catastrophic loss and I was just running the numbers to understand what that might be. I didn’t know my data was faulty, but the real lesson here is that it’s probably a better idea to use STPs even if that means you’ll have more frequent loss (which is still not that frequent overall). The overall strategy is profitable which I agree and have been doing.
Nevertheless this discussion has run its course and no need to continue. Thank you for your time.
Thanks you, too, Joe! 🙂
Two questions or thoughts:
1. Have you considered using VSTN / VXST as it may be better at identifying shorter term volatility than VIX?
2. STPs are useful here but they increase the probability of a smaller loss. I.e. if your strike is 5000 your STP will be triggered at, say, 5100. The probability of the strike being hit should/may be very small but the STP trigger will be much higher. How do you handle this?
Although you asked ERN, I will answer the 2nd question.
You can’t eliminate risk. You can only transform it into a different kind of risk.
As you’re question hints, ERN is transforming the risk of large losses into a risk of turning the strategy into being not profitable on average.
But if you look at the numbers he shared since he started using STP’s and 0dte, he’s still profitable with around 50% premium capture rate even for 0dte.
Thanks. If people want no risk, they should invest in T-Bills.
I’m merely saying that taking on the negative skewness risk is the most profitable portion of the equity premium. Nobody pays you for “suffering” upside risk. In fact, lottery-style payoffs are usually a sucker bet and have low or negative returns.
1: I look at the VIX but in practice I use several different short-term risk models I developed myself. VIX is just an FYI because it’s too long-term.
2: Correct. I don’t have a good model for this (yet). But I assume that the higher frequency and lower loss about balance each other, so I still look at the probability of ITM.
Hi Ern, I’d like to understand the strategy edge correctly. Quantitatively your numbers are spot on, I’m sure, but I’d like to get a hold on the qualitative reason of why this strategy works so well.
As I understand, with options you don’t eliminate risk, you just transform it. So you earn a premium for the outcome of some (or most) types of market scenarios, for exchange of taking the risk of some other types.
So I understand that with this strategy, the edge comes from you betting that a prolonged series of downside days will not happen. Or in other words: it builds on the fact, that heavily downside days during low volatility periods, even if do happen, are (1) quite rare and (2) do not cluster (the clustering happens in downtrends, usually in periods of prolonged heightened implied volatility, and is a scenario you deliberately hedge out by using only 0DTE and 1DTE options).
Is that correct?
So I understand that what would hammer the strategy most, would be a rather lengthy, rather lite S&P500 downtrend, sprinkled with frequent “out-of-the-blue” down days (of about 5-7%), clustered fairly close together (but not to close, as to not raise the VIX high enough, as with a high volatility you start to earn higher premiums). A type of sideways, slightly down prolonged market environment. Is that correct?
Also, I’ve seen in one of the posts that the longest drawdown period for the strategy was the bear market of 2000-02. And generally the strategy suffers when the S&P500 does, but usually less so and with lower overall volatility. Can you think of any scenario where the strategy’s drawdown would actually be higher than that of the underlying S&P500 ?
If I understand correctly and ERN can correct me, in a nutshell this strategy is all about probabilistic expectation. I think you are sort of overcomplicating it.
If every day you have a 1% probability of losing $100 and a 99% probability of making $10 your expected value is $10.90 and you should make this bet every day.
The volatility and other stuff is all about estimating the probability of winning. You have to get that as right as possible otherwise you lose money.
I think the problem most people are concerned about is that actual probabilities here are more like 99.9% win $100 and .1% lose $100k. That is still positive expectation but how many times can you lose $100k?
IMO the real “problem” if it is a problem is that 1) you don’t live forever and 2) you can only play this game 1 or 2 times per day. TBH the $100k loss I mention is sort of fake in that using STPs you limit that to a smaller figure.
But still if you lose $8k in one day it still can take a while to make that up even though theoretically you eventually will.
That’s why scaling the bets is important. Never lose so much that it will become impossible to dig out of the hole. Hence, the STPs and only very modest leverage and lots of extra capital, much more than the minimum margin constraint.
My post example was mathematically off. I meant 99.9% win $200 (not $100)
Noted! Not too different from my skewness numerical example.
You harvest the best and most profitable portion of the equity risk premium.
False. Since I reset the 0DTE and 1DTE every day, not only would a prolonged downside not hurt me. Quite the opposite, those are the most profitable times, because IV will be high and the subsequent puts will be so far out of the money that they never get threatened to lose money.
The concerning scenario would be an “out of the blue” market drop during an unusually calm period when IV is low and premium and OTM-% are low. But then again, those are rare and the % drop is usually moderate.
But isn’t that just… leveraging the equity risk premium? I mean, you already have it in the stock portion of the portfolio, and you add it again. Isn’t it similar to just leveraging the stock portion of the portfolio?
I think one user already made that suggestion above (700SAIKUMAR), and you’ve replied it’s a totally different strategy, but I can’t shake the intuition, that it is very similar, just with the risk more localized in single down days occurring in low IV environments.
You have in this option strategy:
– essentially the same periods of over- / under-performance as for the stock index (2000-02 bear market, 08 bear market, 2022 bear market, etc.),
– a very similar drawdown curve as the stock index (though not as severe),
– a small (although non negligible) risk of a very big down day here and there, bigger than for the corresponding index (during low-vol periods),
– which you manage by using Stop Loss orders correctly,
– you need to manually reset all the options every day (because of using 0DTE and 1DTE options),
=> I can’t seem to understand how this differs much from just buying the stock index with a little bit of leverage. I mean – it looks and feels the same, just without the additional hassle of 15-30 mins per day of reviewing and selecting options, typing in stops, the thrill of it all, etc.
Where’s the catch, what am I missing?
It’s clearly not the same strategy as leveraged equity. 1x equity has a return of 7-10% and vol of 16%. My alpha has aa return of 4-5% and a vol of 0.5%. How will you generate 4-5% extra returns without almost doubling your vol when using only leveraged equity?
Maybe I mixed up something. You show a longterm backtest drawdown of the (put writing) strategy in Part 3 (between 2000 and 2018), and it goes down way to -30%. Is this the same equity curve we are talking about with the vol of 0.5%?
That chart is for the CBOE put writing index that does only monthly puts. I do daily. Very different strategy. It can have very significant equity beta exposure, while my strategy is almost uncorrelated with monthly equity returns.
Great! In that case I was wrong, that’s where the mix up came from.
Could you point me to a longer backtest of your daily strategy? I found the chart in part 11 (from Dec 2017 onwards) of cumulative alpha, buy maybe you have some longer-term backtests? Also, is the daily equity chart (and drawdowns) significantly different than the chart in part 11?
I have longer return series, but they become increasingly irrelevant because my strategy evolved over the years.
But, yes, the drawdown chart is much nicer than either the equity or the CBOE Put Writing index.
When you calculate your P&L, are you taking account of the opportunity cost of your cash position? If I understand correctly, you have $7k in cash per contract and 20 contracts. So that is $140k in cash at IB at about 1.5%. That could have been invested in SPY, preferred shares, CEF etc.
I don’t think it changes your gross profit that much but might be more accurate.
No. In retirement, I want a bit of a cash cushion for cash flow access. I would have that even without the options trading.
Also, you get paid interest on your cash balance at IB.
Well, there’s still an opportunity cost because IB pays subpar interest rates, typically about 1% under FOMC. Their blended interest rate on 140k is currently 2.9%, which is about 0.8% less than Vanguard cash sweep (VMFXX). That is only about a $1100 annual cost on 140k, so not a big deal in the grand scheme of things (assuming a profitable strategy).
Well, there’s an opportunity cost everywhere. If I wanted to switch Vanguard, I’d have $1100 more in interest income but I’d have a stone-age trading platform that would make it impossible to run my strategy. That opportunity cost would be $100,000 a year.
Also, I’ve reduced my cash holding target to now about $60-80k.
Hi Karsten, I’ve started learning about options after listening to you and Jason on twosidesoffi. There is one concept I’m struggling to understand. How to you put stop loss orders on your short puts? I’m trying to do so at the same time I place the short put (paper trading), and I’m not sure what settings to use. For example, should the stop “buy” order have the same strike price as the “sell” order and then I just adjust the buy order price up by 1.00 or so?
Even then, what event will trigger the stop loss? Does it occur once the strike is met or surpassed and then both options are exercised and my account is deducted the difference in premiums?
Also, when I try to setup such a stop order on thinkorswim, the stop order shows as more expense premium-wise than the credit I’m getting for selling the put. If
that is the case, how can I profit?
In Interactive Brokers:
You right-click the position. You select “Close” and set the order type to STP and select the Stop-Loss level.
You need to set the stop level, of course higher than what you got when you sold the puts. In case of a STP you will lose money. The idea is that you lose money only with a small enough probability hat you still make money.
Have you ever experienced any period time where premiums dried up so much that it simply wasn’t worth taking the risk? Example would be a time where you had to go closer to the money than what you felt comfortable with and/or the premiums became too small ($0.05)? Do you have a way to detect a situation where the premiums just aren’t worth the risk being taken?
I would still sell 0.05, usually a reduced number and see if I can do more 0DTE the next morning at 0.10.
Hello,
Thank you for this valuable information! I have been using your strategy for the last couple of weeks and learning a lot. So far, PCR has been 100%.
Lately, I’ve been trying to optimize my short put pricing (not sure if this is the correct term). In a previous post you mentioned you try to price in the middle of the bid-ask. I was doing that and I noticed it filled immediately. So the last couple of days, i started to price at the “ask” price. This is a +20% uplift ($0.30 vs $0.25) and I noticed my orders still fill within 10-20 minutes. This seems to indicate there is liquidity and willingness to buy. I’m curious if you have tracked metrics like time-to-fill and tried to optimize pricing? It seems like a no-risk way to improve profitability. In my case, I usually initiate my short put 30m before market close at the ask price. If it doesn’t fill within 20minutes, i’ll lower the pricing the the “mid” price to fill it immediately.
thank you
My approach is similar. The timing might be different but I try to “fish” for good deals. If nothing fills, put in a limit to split a 10-cent-wide B/A spread at a relatively strike and that fills much faster. I don’t have any hard data into how well that has worked, though.
In part 2 of the series, you calculated yield on your eMini. I am curious if you’re still doing that with SPX.
Yes, I do. The calculation is still the same: premium / index / t (where t is on years)
The only difference between part 2 from 2016 and today is that I target lower yields.
Got it. Yes I noticed SPX 1dte yields are far lower. But my guess is you’ve scaled up due to lower delta and higher PCR. And I could see how your rate of return is still around 4% so a $1M portfolio would net out $40k or more accretive just from short puts.
Currently, I’m hoping for 4.0-4.5% extra return from 0DTE+1DTE puts plus 0DTE calls.
Hello Big Ern:
I had read most of your posts around 2018, then life got in the way and have stayed away… now after a 7+ year hiatus, checking things out again,
1. Is the 1.7% “alpha” mentioned in the post relative to funds at IB (i.e., while your 140K at IB is earning (say) 6% in various bonds/cash, you are able to effectively boost that to 7.7%), or is that 1.4% boost to your entire portfolio? For the latter, assume you have 20% at IB in these fixed income; and 80% in ETFs at Fidelity. Then is the option alpha so large that it increases your entire portfolio’s blended return by 1.7%?
2. You mentioned in one of the replies that you would consider running small managed accounts. Have you started doing that, for anyone wanting to invest that way?
Engineer
Sorry, it should be “read”, not “ready”, in the first sentence.
Noted. I corrected the original comment.
1: No, the 1.7% used in that example is for the entire account. You don’t get to leverage that again. That would be way too risky.
2: I onboarded a number of advisory clients earlier this year. I don’t plan to add to that group because it would take more time out of my day handholding more managed accounts. If that ever changes and I plan to bring in more money I will announce this here.
It seems the biggest risk in this strategy is the overnight gap down risk due to a black swan event. Assuming you have a 1DTE short put and the market has closed. You don’t yet have a stop-loss protecting you since you only use that to manage intra-day risk and put the order in during the next trading day. To manage the rare over night gap down, could you buy a put on a futures contract (MES) when you notice a gap down in futures?
As example. assume I short put SPX 1dte. The strike price is 6000 and the market close price is 6500. So it is 7% out of the money. I set up a notification to text me if the futures are -6% or more. This tells me there is a gap down and when the market opens, I may be at risk of being in the money. To counteract that, i will buy a put on the futures at a strike of 6000, to match my short put. And this could be bought at night as the gap down is occurring since MES trades 24/7. If this is correct, then I would no longer need to the Stop Loss on SPX when the market opens and I’ve mitigated & capped downside risk due to the gap down.
Is this approach viable?
Yes, you could do that. But liquidity is slim overnight.
Doing a delta hedge via ES or MES futures might do the trick. But you also give up some income if the market rallies overnight.
Thanks for great article! Would be happy to ask few questions.
1. 0DTE – can you elaborate why you keep 140k margin ? If you have stp relatively close ( let’s say 2.5) the loss is 235 USD assuming you sold the put on 0.15.
2. 1DTE – how do you set stp order for those? Iiuc stp not working out of trading hours the same as in trading houses.
Thanks!
1: This is only for the 1DTE. I like to keep the number low enough (i.e., capital per short 1DTE put high enough) to avoid the IB exposure fee. Intraday, i.e., 0DTE I max out the margin.
2: There is no efficient STP overnight. But I have manually liquidated positions during the off-hours.
Thanks for great article! Would be happy to ask few questions.
1. 0DTE – can you elaborate why you keep 140k margin ? If you have stp relatively close ( let’s say 2.5) the loss is 235 USD assuming you sold the put on 0.15.
2. 1DTE – how do you set stp order for those? Iiuc stp not working out of trading hours the same as in trading houses.
Thanks!
same question as the other one. Please the my answer there.
Thanks for sharing this, its really detailed and informative.
Will this 1DE and 0DE strategy work for Nasdaq100 index the same way it works for SPX? Any reason why you selected SPX?
Good question. I have not used this strategy on the Nasdaq. You get the most liquidity with SPX. But the strategy should also work with the Nasdaq.
Hello,
I’ve been using your strategy for 30 days with good success. I’ve tried to optimize my short put premium by setting up some simple expected value calculations. I roughly use delta as the change of going in the money. I understand it is not exactly linear so you don’t get 2x the premium for 2x the delta. I’m curious how you think about optimizing this. I try to stay between 0.5 to 1.5 contract delta but curious if I should go higher at the risk of higher frequency of payout.
Expected value calculations are key. But notice that the delta only gives you a probability not a loss. You still have to multiply the probability by the conditional in-the-money amount.
ERN, did you look into ibkr conditional orders as protection against black swan outside RTH
E.g if SPX drop below 6100 buy the sold put.
Oh, if market orders arent allowed outside rth it won’t work.
Correct.
Could there (or has there) been a situation where option liquidity dried up such that no one was selling the option you already sold and a small number of buyers put very large bid prices that would cause your stops to go off, leading to losses much much larger than your stop loss (think 100x instead of 10x of your option premium)? Of course that situation I described is very unusual and I know your strategy has worked for many years. However, I also read that you started stops in more recent years so I don’t know if some previous market situation could lead to much more damage than your typical stop loss. I suppose if that really were to happen, it would be better just to let the option expire and land in the money (if it does).
I have not experienced that. Even on April 9 there was enough liquidity to get out during the +10% rally.
It was going pretty well since last 4 months, when i got assigned on October 10. What i dont understand is that i had stop loss with limit, at 30x premium, and it didnt trigger. Why would this happen?
Is the mitigation to put stop loss with no limits? If so, can market orders be exploited by market makers to give subpar fill? Im using ibkr lite
After that it was psychological errors as i convinced myself that this is market overreacting, and i watched the market sink further
Lesson learnt the hard way.
2. It is possible that even though option is otm; the price may spike triggering the stop loss right? If so, It just feels strange to be making loss even if option is not itm. Are there more efficient ways to control such tail events?
Are you using IB or another broker? I’ve heard that it’s possible the STPs are paused during periods of extreme volatility, but October 10 was not particularly crazy vol.
I’m wondering what you think about diversifying 0 DTE option sales across the day instead of all at the same time (i.e so some at the market open, some an hour later, etc). In Oct 10th I sold puts just before the sharp dip that morning, hitting my stop losses. If I spread them out so I did a some at this hour, some more an hour later and more after that, my results would have been very different.
Is the optimal strategy to have 0 DTE be right at market open or could this strategy work at various times during the day. Of course as time passes, the premiums at the same strike will go down (if the market doesn’t move towards the strike) due to the clock running down, but you could always go a bit closer to the money too.
That’s possible, too. I sometimes spread out my trades through the day. The first 15 minutes opening window is still the best, on average.
Hi Karsten
Thanks again for all the time you spend anwering your community’s questions.
I have a few practical questions:
1. Do you use live data or for the decision making? or only past data (for the risk calibration)?
E.g. is there a smart way to pull the premiums Bid / Ask per strike in IBKR to feed into a python script or csv file?
2. When you set the STP, do you use a simple heuristic (“X days of premium profits”) as you suggest in some of your post, or do you go as far as calculating some sensitivities (using greeks for that)
Thanks again
1: I have the real-time quotes on my IB screen. I calculate the risk model and expected losses by strike with Python with live data on the S&P index only. I have to mentally compare the two data sereis side-by-side. Ideally I’d like to load the live options quotes into Python as well. I plan to implement that eventually, but it’s not ready yet.
2: Simple heuristic. What exactly it is, I won’t publish. First of all, the exact value doesn’t matter too much. What matters is that you have a STP, not so much whether it’s at $1.00 or $2.00 or 10x or 20x premium. Second, I don’t want to publish my exact methodology because I don’t want a ton of other traders front-running my STPs, i.e., undercutting my STPs by 0.05.
That makes a lot of sense. Thanks a lot for all the transparency that you already provide