I found this blog one year ago thanks to Nick Maggiulli; I am quite fond of it because it provided me the solution to my quest for leverage: Interactive Broker. I spent some years looking for a bank that would accept to give me leverage holding my stock portfolio as collateral only to get doors smashed on my face; I even contacted friends working for other banks who told me that my requested service was available only to HNWI. This Canadian guy solved a big issue for me, thank you!
After the IB discovery, I was quite excided to explore further the blog: how many other profitable ideas might be hiding there? Narrator voice: zero (this is related to me, does not mean that you will not find useful content for youself). At least, I found some material for the blog. The guy recently started an income losing strategy: selling options. Actually, selling puts is a losing strategy, covered calls are fine and I might touch on this in a future post.
The Naked PUT Strategy
A naked put is an options strategy in which the investor writes, or sells, put options without holding a short position in the underlying security. I read about this strategy a…decade ago? probably in one of the Market Wizards books…but I am not 100% sure on this neither. Anyway, the story is this: you think XXX (put your favourite company here) is a great company but its stock price is too high for you now; in a normal situation, you would simply wait that the market goes in your favour, i.e. down, so you can buy it at your target price. But you do not like to wait, time IS money as they say. So you can sell a put option on XXX at your target price: if the stock goes down, bingo you get your asset at your price; if the stock goes up, you can keep the premium you got selling the option. A win-win strategy!
Or as freedom35 says:
So to break down this put option, here’s what it means.
- The option buyer paid me $209 for selling this option. Yay money. 🙂
- Any time before July 16th this year, the buyer can choose to sell me 100 Apple shares at $115/share.
Apple stock is trading at $131 now. That’s 14% higher than the option’s strike price. There’s no way the option will be exercised today. Why sell their asset to me for $115, when they can sell it at a higher price on the open market for $131?
So between now and July 16th, if Apple shares fall below $115 there’s a chance the option will be exercised. That’s fine with me. If I can buy AAPL at a 14% discount from today’s price I’m happy. 🙂 And if AAPL continues to stay above $115/share, then the option will expire and nothing will happen.
The first mistake
The cognitive issue with this strategy is that you think you will get TODAY’s Apple at a 14% discount. In reality you will get a DIFFERENT Apple, the one that lost 14% (or more!). What I mean is that if Apple lose 14% there has to be a reason, including: accounting fraud, new iPhone sucks, China bans sales of US products, or…, or…
The scenario you have in your mind is this one:
The stock takes a ‘pause’ (white arrow), you take advantage of it and then you enjoy the ride up (red arrow). What happens in reality is this:
You see a stock that goes up and up, you get in love. But you do not feel to buy while the price increases (hey, you are not alone, momentum strategies works for a reason!), so instead of simply waiting for a pullback, you sell puts…and when you are filled, your love is in a lawsuit that put it out of business.
“But my stock selection is so rigorous I will never choose a stock like that!“
Then buy the stock.
The fundamental issue with this strategy is that is suboptimal if you are a good to great stock picker. Who cares about a 14% discount if the company is going to the moon? You are getting an annualised 3% (using the blogger example) in the hope of a pullback while giving up all the potential upside. But for your 3% you get all the downside; and shit happens, we just passed (is it over?) a virus that no one had on their radar a year ago. Sure, it turned out that it was a great opportunity to buy even those stocks that WERE bankrupt like Hertz but again, if that is your idea, ‘your’ stocks only go up, then buy the stock.
The second mistake
The reason I started to trade options is to see if I can make some easy money. 🙂
Trading options allows me to leverage the dormant capital of my existing stocks. I can capitalize on my $270,000 portfolio by earning regular income via option premiums without investing any new money. In the rare case that I’m assigned a new stock, I can simply pay for it with a margin loan.
If you sell a put and you are not short the stock, your broker will ask you a collateral. This is because if the option buyer decides to exercise the option, you HAVE to buy the stock from the option buyer (the optionality is on him/her); the collateral is your broker ‘insurance’ that you have enough funds to make the purchase. In Freedom35 case, the margin loan starts once he sells the option, not in the rare case he’s assigned a new stock. The collateral required can be cash or, for IB users, other stocks. The collateral amount is not fixed, it depends on the option mark-to-market: the more the price of the stock gets closer to the option strike ($115 in Freedom example), the higher the collateral that has to be provided by the option seller.
This difference is important once you start to pile up positions, or leverage your dormant capital. The easier situation to manage is when you have only cash on your account and your broker gives you no leverage: if you have $1000, the maximum amount of options you can sell is $1000 / option strike price. If strike = $10, you can sell 100 options, with each option giving you the obligation to buy one stock. The day you sell the options, your broker is not going to set aside the whole $1000 as collateral but only a part of it. This situation allows you to not care about any margin call, the max you are going to spend is $1000, but the yield you get from the option premium is very low, few % points that depends on your chosen stock volatility. To increase the yield on your initial capital, $1000, you can sell more than 100 options or even better, sell options on various, uncorrelated stocks in the hope that the combined mark-to-market will never exceed $1000 plus the premium you got.
Freedom35 example is not that straightforward. It is true that he has some dormant capital (due to leverage) but this capital is not infinite AND is correlated to his stock portfolio: the lower his portfolio goes, the lower the margin IB gives him because its collateral value is going down; at the same time, the mark-to-market of the option he sold is going UP and therefore the collateral IB requires from him (assuming that stocks are 100% correlated, we know that normally is not true but in rare cases, when shit hits the fan, it is). Once the collateral requirements exceed the available collateral, IB starts to close your positions and crystalizes the loss you accumulated up to that point.
In the no-leverage situation, you get bond-like returns (a bit more TBH) BUT you need to research for stocks, so the strategy is not efficient. In the leveraged situation, you think you are creating income out of no-where but in reality you are exposing yourself to a margin call risk.
How big is this risk?
I will continue to sell Puts using strike prices at 2 standard deviations out of the money. That basically means my options will have a 95% probability to expire worthless, which is the ideal situation for me.
I read the Taleb book about options years ago and my brain still hurts; every time I listen to Corey’s podcast I realise how little I know. This is just a bit of evidence to show that trading naked options is a very complicated task. Even with my limited knowledge, I spotted two errors in F35 sentence:
- that 95% probability is based on the assumption that stock returns follow a normal distribution, which is fine for academics (formulas are easier) but does not hold in real life. Stock returns have ‘fatter tails’, meaning that rare events happens more frequently than suggested by that 5%
- if we assume fatter tails, 7 or 8% of the time naked put options will generate a loss: what we really care is not the frequency of the loss but its magnitude! When single stocks dive, they freaking dive big big time.
This is a risk management issue similar to p2p loans. When your tail risk is a 60, 70 or 80% loss of capital you want returns high enough to cover for that risk; this is the reason why I always suggest to stay away from p2p platforms that offer returns less than 10%: the risk you take is not compensated enough. Here is the same situation: 3% to take this additional risk is not remotely close to fine.
The Wheel
F35 introduces a strategy, called The Wheel, that I never heard of.
- You start by selling Put options to generate income. Most of these should expire worthless.
- If any options are assigned you sell Call options above the cost basis on the assigned stocks.
- If those stocks get called away, you make a profit from buying the stock low and selling high. 🙂
Ok, what if the stocks you got assigned continue to go down instead? I read a couple of articles around and yes, this strategy is really THAT stupid. Some articles suggest you (at least!) to manage the risk using a stop loss: if so, this strategy is again predicated to your stock selection ability. The difference is that instead of looking for stocks that will go up (your upside is limited by the put and then the call), you aim to avoid stocks that will go down…but are still volatile enough to generate enough premium to cover your costs. Is the potential gain worth the effort? Surely it does not look that passive…
Have you ever heard about “picking up pennies in front of a steamroller”? Taleb, again, likes to describe strategies like this one with the Thanksgiving Turkey metaphor:
The ONLY two cases where this strategy might make sense
The first is a ‘tongue in cheek’ case: if you are managing someone else money, get paid a performance fee like an hedge fund manager, and do not care about your clients’ money like an hedge fund manager, this is a profitable strategy. Your fund equity line will look like this:
The fund generates constant, stable returns and your clients gladly pay you a performance fee. Once the ‘surprise’ event happens, your clients lose all their funds but you get to keep your fees. Easy Peasy. This was also the strategy of many proprietary desks inside commercial banks before the 2008 crisis: traders kept their bonuses and when the bank went bust…taxpayers paid the bill.
As you can see, this is a very stupid strategy if your money is involved.
The second case needs some caveat first. These are the fundamental and absolutely necessary ingredients if you want to run this strategy:
- instead of stocks, you have to write options on very diversified and broad stock index: possible candidates are the World Equity Index and, to a lesser extent, the S&P500. Running it on the Nasdaq or any other single country index will be too risky for me.
- you believe you can ‘time the market’ when fundamental valuations reach extreme levels
Let’s say you are worried about the current World Index fundamental valuation, measured by P/E or CAPE or P/B or… . You know that the best investment strategy is to buy and hold but still it helps you to sleep at night to de-risk your portfolio in this particular situation. So you reduce your allocation to stocks and instead sell puts on the index with strikes at a lower, more fundamentally palatable level. This way, if the ‘bubble’ (as you see it) continues to inflate, you at least gain the yield on the puts; if it pops, you become a forced buyer, something that is actually helpful in case you took the active decision to deviate from you strategic asset allocation. Do not implement this strategy if you want to maximise your returns because…it does not.
What I am reading now:
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