The next interview in the series is with Mr. ERN. An experienced option trader with an interesting put selling strategy. His blogs brings some challenging thoughts like the reasons not to have an emergency fund. Make sure to check it out.
Q: Tell us about yourselves
A: We are Mr. & Mrs. ERN, a married couple with a little daughter and we plan our early retirement in 2018. We could theoretically retire now but we also like to accumulate a bit more of a cushion in the early retirement fund. Besides, Mr. ERN still likes his job. We are interested in everything finance related and started our blog in March this year to document our journey to early retirement and discuss all the related topics in finance, personal finance, budgeting, etc.
The more hardcore finance topics, including options trading, are covered by Mr. ERN, both on the blog and in practice, so you might notice “we” and “I” in our responses and when it’s the latter it’s Mr. ERN speaking.
Q: How did you get an interest in option trading?
A: A long time ago, I found out about the concept of covered call writing. It’s a paper by Robert Whaley. He showed that these kinds of strategies have superior risk-adjusted returns relative to equities. The original paper is published in a journal (Whaley, Robert E. (2002): “Return and risk of CBOE Buy-Write Monthly Index,” Journal of Derivatives, Winter issue, pp. 35-42.) and due to copyright issues I will not put it here, but here is some additional and updated research in that same vein available for free on the web:
Average returns of covered call writing and naked put writing are similar to the index return but their risk is significantly lower, about 2/3 of the underlying index risk. That got me thinking: why not implement this with Put options on futures and easily scale up to a desired risk level? I’ve been using the option writing strategy live since early 2011, initially with a small amount, but that has now grown to a pretty sizable portfolio.
This also fits in well with our approach of scaling up leverage to compensate for the impact of marginal capital gains taxes, which is a way of generating Roth-IRA-like returns in a taxable account without any contribution limits. We call this a “Synthetic Roth IRA.”
Q: What actions did you take to learn about option trading?
A: I work in the finance industry and have good knowledge of all the option math. Both from a theoretical perspective (I hold a PhD in economics and the CFA charter) and from practical experience at work with portfolios of futures and options.
When I started trading for myself I began small with a play-money-sized account in case it doesn’t work. Sure enough, after 4 months we had the August 2011 meltdown and I lost more than half the account. That’s because I used way too much leverage. After learning that lesson I put a lot of new money into the account and kept much more margin cash per short Put position.
Q: What is your goal/ambition?
A: In general, our goal is a comfortable retirement while funding our annual expenses with passive income supporting a withdrawal rate around 3%. For the option writing strategy, we target stable income from Put option writing to have a hedge against an extended sideways/range-bound equity market. Incidentally, this is what we suspect could be in store for global equities in the next few years. We currently target a return of about 8-10% p.a. before taxes from the options alone plus another 2.5% of (tax-free) Muni bond interest and 6-8% annualized volatility. When we eventually retire we like to run this strategy at a slightly lower leverage, though, because our marginal tax rate is lower. Over the years, we beat our target handily (higher return, lower realized risk), but we budget very conservatively. Even with the disastrous August 2015 event and a few other recent drawdowns that sent the puts into the money, we did better than expected.
Q: What options/derivatives do you trade and why?
Currently, we exclusively sell naked put options on S&P 500 e-mini Futures (ticker ES). One contract has a multiplier of 50, so a notional value of a little bit above $100,000.
I have never traded any individual equity derivatives because of compliance issues at work: I would have to pre-clear each and every trade with our compliance department. These guys want to make sure that employees on the investment side of the firm don’t front-run trades that the firm wants to put out. Futures markets, obviously, are so deep and liquid that our compliance department doesn’t seem to care about my personal trading activity.
Another issue is the treatment of index futures and their options as Section 1256 contracts under the US tax code. This means that I don’t have to itemize any of my trades; we trade about 1000 (!) option contracts per year (20 contracts every week, every week), so that matters a lot to us! We just report the cumulative net profit on IRS form 6781 and our full calendar year of trading of futures options takes 30 seconds during tax time. The preferential tax treatment of capital gains as 60% long-term and 40% short-term (even with our holding period of just a week), is also a big plus for the Section 1256 contracts.
Q: What broker do you use?
A: We use Interactive Brokers (IB) for our Futures Trading. The commissions are quite low: per contract it’s $2.03 for ES Futures and $1.41 for ES Futures Options. This is for the E-mini contract with a multiplier of 50, so a notional of over $100,000 and a put option contract value of around $100-150 (=$2.00 to $3.00 times 50). We have no relationship with IB for referral fees, so this is our unbiased opinion. For full disclosure, the customer service is slow and inefficient and we sometimes have the feeling that they rip us off with little fees here and there, so please don’t consider our pick of IB a full-blown endorsement. But they are the lowest-cost provider overall for our personal trading needs.
Q: How do you describe your style? Did this evolve over time?
A: Some people trade options only sporadically, e.g., sell puts to purchase a stock at a discounted entry point. Once having taken possession, people then sell out of the money (covered) call options to collect income. We take a very different route. We sell naked puts every week (on Friday) with an expiration date in exactly 7 days. Early on, we sold Puts with a longer term, up to a month, but we have now shifted to puts with 7 days or less to expiration.
In our trading, there is very little tactical timing involved. We do the same strategy every single week: sell a certain number of out of the money Put options. Then cross our fingers that the index doesn’t drop below the strike price. If the price stays above, the options expire worthless and we made the maximum profit. If the index drops below the strike price, we sell each Futures contract within a few seconds of taking possession. We have no intention of holding the equity exposure because we have plenty of it already in our other brokerage and retirement accounts.
Q: Markets are efficient. Then why should any of this option writing business work?
A: Efficient markets are the reason why this works. Whether you sell naked puts or covered calls, you voluntarily subject yourself to the most undesirable and unattractive payoff profile possible: limited upside and unlimited downside potential. The exact opposite of what everybody wants. The efficient market compensates you for taking losses when they hurt the most.
Why is there not more supply of downside insurance? Nobody has the stomach anymore. Big institutional investors, like pension plans, are actually net buyers of downside protection. If you work for a pension fund or endowment you have a great aversion to downside risk because one big drawdown is all it takes for you to lose your job. Even if the market recovers again eventually it’s of no use if you got fired. Career risk for money managers creates demand for put options. I don’t have that career risk because I manage my own money.
Banks face a lot of regulation and can’t afford to take on more risk and drawing the regulators’ scrutiny for a few percentage points of extra return per year. Hedge funds and private investors with a long-term focus and a stomach to sustain temporary short-term losses (and an understanding spouse!) seem to be the typical investors pursuing our strategy.
Q: How much time do you spend on trading options?
A: On Fridays I sell a new round of puts. The actual trading takes very little time, probably 30-45 minutes total. I also prefer to do this on the simple iPhone/iPad trading platform. It’s much easier to navigate than the full trading screen on the desktop computer. We are not market timers and flashy charts and busy colorful trading screens are mostly a distraction to us.
Throughout the week I monitor how the positions are doing but try not to intervene. That’s not much of a tax on my time because I work in the finance industry and keeping an eye on the market is part of my job profile already. Every weeknight I get an email from IB, and I enter the P&L into my spreadsheet. That takes a few minutes every night.
Q: How do you deal with the risk that comes with option trading?
A: I calculate how much risk I’m taking on. I do that several different ways:
1: monitor how much delta risk we are taking on at any given point in time, that is, how much we stand to gain/lose by moves in the ES future at the current time. This delta will vary over time, of course.
2: Basically, a Value at Risk (VaR) type model where I look at how much we stand to lose in case of a market move of different magnitudes. Since we use leverage it’s important to keep an eye on this. From the annual implied volatility (VIX) I calculate what’s the weekly implied standard deviation, and what’s our expected loss at 1.5, 2.0 and 3.0 standard deviation down moves. As a rule of thumb, at 1.5-sigma I’d like to lose less than the underlying index (basically get barely into the money), at 2.0-sigma I’d like to lose roughly the same as the index, and at 3.0-sigma I’m willing to lose quite a bit more than the index.
3: We are aware that returns are not exactly normal, so I keep a record of historical weekly returns, expressed as multiples of weekly volatility (z-scores). Not surprisingly, a 3.0-sigma event happens a lot more often than a Gaussian Normal Distribution would predict. Being cognizant about this actual realized distribution with negative skewness and excess kurtosis is important when selling put options with leverage.
Q: What tools/sites/blogs/podcasts do you read on option trading?
A: You encounter some people here and there who write something on the option basics, but I haven’t seen anything worth reading until I stumbled upon the blog by Amber Tree Leaves and the people featured there in his interview series.
I use an add-in for MS Excel to perform all the option calculations (implied volatility and the Greeks) and this includes the Excel functions options on futures, which have slightly different formulas. It came with a book by Robert Whaley and his book is also the standard reference that I keep on my desk at work on everything derivatives-related.
Q: What is the size of your option trading account?
A: It’s in the mid 6-figures US$. About 20% of our net worth.
Q: Where do you get inspiration for trades?
A: In our trading there is little inspiration in that sense. We do the same thing every week. Our experience has been that discretion is counterproductive. There is the urge to take a break from selling downside protection right after a big drop, but you’d miss the best opportunity for profit because once everybody is scared and the VIX spikes we can sell puts so far out of the money that it’s unlikely that we lose money. Our biggest losses occurred when the VIX was low at inception and a big drawdown came out of nowhere.
Q: How do you track your trades and P&L?
A: We use a spreadsheet to track the following:
1: daily P&L and inflows and outflows into/out of the account to track both IRR and time-weighted returns of our strategy.
2: compare our returns with S&P500 total return index returns, which is essentially our benchmark.
3: realized weekly and monthly returns for return stats calculations, e.g., Sharpe Ratio, equity correlations, skewness, kurtosis, etc. of returns
4: every single option trade (entry, exit and expiration date, price of underlying at initiation, profit/loss at expiration/close, other stats like initial implied volatility, Delta, Gamma, Vega and Theta at inception). This allows us to monitor realized payout ratios.
Q: What is the worst trade ever you did?
A: Since we have very little discretion in our trades I am hesitant to call some trades good and others bad. In my personal opinion, they were all almost equally good ex ante, but some turned out better than others. We are a little bit like the slot machine at the casino; ex ante we should make money, ex post we make a small amount with a high probability and pay out a lot of money with a small probability.
But, anyways, what were our worst returns? It depends on whether we are talking about relative or absolute/dollar terms:
In percentage terms: Definitely the puts I sold in late July 2011 that went sour in early August 2011 when the market dropped precipitously due to the stalled congressional budget negotiations and fear of default. That wiped out more than half of the account because I took way too much risk. Lesson learned. After that I set aside much more than the required minimum margin.
In dollar terms: August 2015 was the worst drawdown in dollar terms (but not in percentage, due to higher principal amount in the account). We lost around 20 weeks of option premiums for the Puts expiring on August 21, 2015. But the calendar year 2015 was still very profitable because of three reasons: there were no more sizable losses after that, volatility was high and we made a lot of money selling insurance after the crash, and our Muni bond fund made great tax-free income and appreciated very substantially. In the end, we still made around 16% that year.
Q: What is the best trade ever you did?
A: Selling puts you have only limited upside potential, so I have no killer trade to show that made lots of money. As mentioned above, we are a little bit like the casino in Las Vegas that has to pay out big amounts every once in awhile, but nevertheless makes money over time, one small amount at a time, 90% of the time.
The trades that I’m proudest of would be the ones after the big selloff in August 2015 when you could sell put options at very rich prices over 150 S&P points out of the money. Volatility was elevated and during the first few weeks after the meltdown we made a lot of the money back because suddenly everyone wanted to buy insurance. Having a good robust stomach and not losing your nerves when selling insurance at a time when everybody thinks the world will end was one of the best trades we made. Same in 2016. We lost money in the first week in January and second week of September, but we made very good returns with our options trading since.
Q: Where/how can we follow your progress?
A: On our site we have information related to options trading:
- Our views on derivatives trading in general
- Our general philosophy on options trading for passive income
- Our actual option trading strategy with more details and recent performance
- Everything else related to derivatives trading