Thanks for the ongoing education.You run a great blog and I enjoyed your 'Rookies' book enormously.
For the past 2 years, I've been selling naked options (mainly puts, a few calls) to generate monthly income.
I sell WAY out of the money RUT puts in the front 2 months using an initial margin limit of about 35-40% in my portfolio margin (PM) account at Interactive Brokers.
I keep the account about 65% invested in dividend paying ETFs and stocks, 35% cash.
As an example, With RUT around 740, I'm currently short the following options:
RUT Dec 540 P
RUT Dec 580 P
RUT Dec 590 P
RUT Dec 810 C
RUT Jan 480 P
RUT Jan 500 P
RUT Jan 540 P
RUT Jan 850 C
I normally sell puts with a premium around $1.00; calls around $0.40.
My position returns just over 1% per month on average on the total account value, which is more than sufficient for our needs.
Over the past 24 months I've had just 2 losing months, in each case losing about one month's average income.
I wonder if you could comment on this strategy? I like to think this is quite conservative, but a catastrophic drop in the market wouldn't be nice…
Should I consider selling credit spreads instead? I assume I would need to operate closer to the money to generate similar returns and spend more time adjusting my positions.
1) NOTE about Portfolio Margin: $100,000 minimum balance is required for a PM account. In addition, margin is calculated more leniently than for Reg T margin accounts. That means you can sell many more options than a non PM customer. Another way to look at that is you can sell far more options than are good for you.
2) This is not a conservative strategy. Not even close. It is a high probability play, with many profitable months. I cannot imagine a strategy in which I earn a profit month after month for several years. Yet this strategy could provide those results. The question is: how much is at risk? That is very difficult to answer. More on that later.
3) Your last sentence explains the dilemma. Yes, you would have to sell closer to the money options if you chose to sell credit spreads instead of naked options. Yes, you would spend more time making adjustments.
The question is: Which is a better situation for you and your money: your current strategy or the alternative of selling credit spreads. And it's a good question with no simple answer.
To me, this is a no-brainer. I prefer to be in the situation of making adjustments, knowing that my losses are limited and that I cannot go broke overnight.
So far, you have come out well. You had two losing months and I'm anxious to learn how you handled them: Did you adjust to reduce risk, or did you hold to the bitter end (expiration)? And when you say 'losing months' does that refer only to the naked option selling, or dos that take into account your significant position in ETFs.
I will never again sell naked index options.
4) I am NOT telling you what to do, but you have not been through what I have. You have not seen how quickly money can vanish from your account. I understand your situation. No matter what anyone tells you about risk, you just know that either nothing terrible is going to happen, or if it does happen that you will react in plenty of time. I know I thought just those thoughts. The people who managed risk for a living were just being silly when they told me that I have more risk that any other market maker in the clearing firm (and it was First Options, a very large clearing firm).
I thought that I could handle it. Even after having been hammered more than once, I made the same mistake again. All I can do is relate the story, issue a warning, and allow you to make your own decisions.
Let me assure you that in Oct 1987, puts were not buyable at any price that you would have been willing to pay. Incredible as it may seem, in many stocks, the bid/ask spread for options was 10 points wide and the asking price for some puts was more than the strike price. Imagine being asked to pay $32 to buy the Nov 30 put – an option that could never be worth more than $30. But when customers were told they had to cover short positions and they had to buy their options at the market price – and do it right now, they paid whatever they ahd to pay. I have no idea whether anyone had to pay above the strike price for puts, but that was a common asking price.
Next, consider the poor customer who was short calls. When IV explodes, far out of the money calls do not sell for tiny fractions. The premium expands. Those who lost tons of money by being short puts were forced to cover their short calls as well. No consolation there because they had to pay obscene prices for puts. Obscene. And this was not the market makers taking advantage of customers. The prices were high because maraket makers had to buy calls to protect themselves. They were selling lots of puts and also shorting stock, when there was an uptick. The only way to protect the upside was to buy calls. So call prices were bid higher.
Back to you Steve
You did live through the winter of 2008, but if you have truly been doing this for 24 months, you began at the right time. You missed out on the excitement of Sep and Oct of that year.
Have you considered what would have happened had you begun in August 2008, instead of 3 or 4 months later? If you have access to TradeStation (or if your broker offers back-testing – I believe thinkorswim does), go back to August expiration, choose options to sell for the Sep and Oct expirations and then follow the trades.
I don't know how much risk you are willing to take, but your note warns me of the danger. You claim to earn $1,000 per month per $100k in your account. You also say that's enough money for your needs, so I'll just guess that this is a half million dollar account and that you pull out $5,000 every month, on average.
You have 65% of your available margin invested in ETFs. If the market crashes, dividends or no dividends, this is not going to be pretty. I assume that you look at risk from the vantage point of those short put options but I don't believe you are considering how much worse it will be because of these ETFs.
If you believe you know what fear is – you have no idea. Imagine a catasrophe in which the market is plunging, IV is exploding, bid ask spreads are getting wider, half of your account is already gone, you want to buy puts but don't know where to begin, and your broker is blowing our your positions (by paying the ask price) to cover your now sky-high margin requirments. Whenever you enter a bid, the ask price just mves higher. That's fear.
I believe you need to do something better with your money. I want you to know that I NEVER suggest how anyone should trade or how anyone should invest. But in your case, all I am trying to do is to be CERTAIN that you understand risk.
Consider this: How much will you lose if the market opens 20% lower one day, RUT IV (RVX) moves to 90 or 100, and the option markets get very wide? You must have this number in the back of your mind. You must have some idea of 'just how bad this can get.'
If you can live with that loss, then you are ok in my book. This strategy may wowrk for you, after all.
The fact that you ask about selling spreads instead of naked option tells me that risk is a consideration for you.
To trade credit spreads, you would buy one option for each option sold. If you still like the idea of being naked short options, rather than short credit spreads, try this compromise:
Continue to sell options as you do.
But do not hold to expiration. in fact, cut your holding period considerably. If you sell at $1.00, then buy them back. Choose a price. Maybe 40 cents. Maybe 25 cents. It does not matter how far OTM they are. Buy them back.
I note you are short several different stike prices. A different compromise is to be short far fewer options. When you sell a new put, cover the old put.
This is not anywhere near an ideal situation because you will still be short naked options. However, you will hold each short for less time, ad that cuts risk. You will hold fewer short options at any one time, and that cuts risk. you will earn less cash, and the one thing that you must not do is increase size to compensate.
I don't like your strategy, but if you understand what can happen – and how difficult it will be to put out the fire – and if you are willing to accept that, then that's your well-reasoned decision. But if you just don't get how bad it can get, then you are taking on more risk than you understand.
Whatever you do, I wish you the best. Just be careful out there.