Short covered strangle on your stock allocation

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HomeBarista
Posts: 19
Joined: Sat Sep 29, 2018 7:16 pm

Short covered strangle on your stock allocation

Post by HomeBarista »

Although this may be better suited for some options forums, I've seen the most thoughtful and in-depth analysis of investing strategies right here. And since fellow boglheads are constantly on the lookout for improving the risk/reward profile of our portfolios, be a the following seems like a suitable topic.

Can selling both out-of-the-money (OOM) puts and calls on the stock portion of your portfolio improve the long term returns of a three-fund portfolio by not adding too much risk?

The above is called a covered short strangle options strategy. For a boglhead investor, a slightly tweaked practical implementation would look like this:
  1. hold the stock long, e.g. S&P500 fund - which most of us bogleheads do (and keep buying regardless of market conditions as usual)
  2. sell OOM calls on your long stock positions, i.e. covered calls since you own the underlying - this caps your return potential, but creates a more predictable income stream and reduces volatility.
  3. sell OOM puts on a portion of your long stock positions, i.e. cash/margin secured put - up to your margin comfort level or how much of the underlying you would normally buy in a given period, such as 3-12 months. If you are buying this stocks regularly anyway, it doesn't hurt to buy them cheaper.
  4. invest the option proceeds immediately according to allocation
  5. should the calls get exercised, get back in the market immediately (see the taxes below to on how to avoid assignment risk entirely)
  6. if the puts get exercised - slow down on your normal stock buying to rebalance back to the desired allocation and/or reduce your margin use
  7. taxes & assignment risk - in practice, to avoid your calls being exercised and realizing capital gains (or having to roll the calls), sell options on the underlying index, such as XSP-mini or SPX for the S&P 500, rather than the fund/ETF you use and just adjust positions as if you were following a covered call strategy. The index options are cash settled and get preferential tax treatment 40/60 short/long term capital gains under section 1256 of the Tax code - not bad at all if compared to federal bonds.
From what I've gathered from the outstanding posts here and from research papers, a covered call strategy (at the money or 2% OOM a month out) by itself decreases portfolio volatility, but also decreases annualized return. There is speculation about better risk adjusted returns. Selling cash secured puts for long positions you are happy to own seems to offer lower long term returns instead of just going long in the first place with the cash. So neither on it's own seems to improve returns. However, combining the too seems beneficial, because assuming short durations for your options (e.g. one month out), it is extremely unlikely that stock prices will move unfavorably for you in sequence for both the short put and call positions. I.e. at least one leg expires worthless. And you still profit from selling volatility (you've added a volatility factor/exposure to your portfolio).

Pros: income generation, diversification by adding volatility exposure/returns to the portfolio (which, I believe, is less strongly correlated with stocks, more info here ), favorable tax treatment if using index options, low transaction cost & bid ask spread issues, speculative (see questions): better risk adjusted returns.

Cons: increased downside risk vs vanilla long stock positions; potentially sacrificed upside, deviating a lot more often from the target allocation, margin risk if used; for investors with higher risk tolerance, because of the inclusion of puts.

Questions:
  1. has anyone researched this in mode details? Could you share your takeaway?
  2. anybody who is doing it - could you share experiences?
  3. has anyone seen good info on whether the short strangle improves returns (especially if the options are further OOM, e.g. 10%), since at least one if not both option are likely to expire worthless.
  4. any analysis on how far OOM and what duration to use to improve returns or the risk profile?
  5. is there a better alternative to achieving a similar outcome?
On transaction costs and bid/ask spreads - before this gets brought up as detrimental for returns, bid/ask spreads on S&P500 options are tiny and a single contracts is of large monetary value. If you want to minimize contract cost, SPX can satisfy the needs of most investors with just a single contract, and SPY and XSP-mini should work well too, so I don't perceive this to be something that impacts returns significantly (unlike the management fee of a buy-write fund, for example).
000
Posts: 2287
Joined: Thu Jul 23, 2020 12:04 am

Re: Short covered strangle on your stock allocation

Post by 000 »

Every time I've looked at something like this it seems the strike prices I'd be willing to write have too low of premiums to bother.

In other words, the market for major index options seems efficient.

Another thought: inflation can cause stocks to appreciate in nominal terms only. So I'm not sure I want to use nominal prices as my rebalancing points.
countdrak
Posts: 60
Joined: Fri Jan 13, 2017 12:47 pm

Re: Short covered strangle on your stock allocation

Post by countdrak »

HomeBarista wrote: Wed Sep 16, 2020 1:56 am Although this may be better suited for some options forums, I've seen the most thoughtful and in-depth analysis of investing strategies right here. And since fellow boglheads are constantly on the lookout for improving the risk/reward profile of our portfolios, be a the following seems like a suitable topic.

Can selling both out-of-the-money (OOM) puts and calls on the stock portion of your portfolio improve the long term returns of a three-fund portfolio by not adding too much risk?

The above is called a covered short strangle options strategy. For a boglhead investor, a slightly tweaked practical implementation would look like this:
  1. hold the stock long, e.g. S&P500 fund - which most of us bogleheads do (and keep buying regardless of market conditions as usual)
  2. sell OOM calls on your long stock positions, i.e. covered calls since you own the underlying - this caps your return potential, but creates a more predictable income stream and reduces volatility.
  3. sell OOM puts on a portion of your long stock positions, i.e. cash/margin secured put - up to your margin comfort level or how much of the underlying you would normally buy in a given period, such as 3-12 months. If you are buying this stocks regularly anyway, it doesn't hurt to buy them cheaper.
  4. invest the option proceeds immediately according to allocation
  5. should the calls get exercised, get back in the market immediately (see the taxes below to on how to avoid assignment risk entirely)
  6. if the puts get exercised - slow down on your normal stock buying to rebalance back to the desired allocation and/or reduce your margin use
  7. taxes & assignment risk - in practice, to avoid your calls being exercised and realizing capital gains (or having to roll the calls), sell options on the underlying index, such as XSP-mini or SPX for the S&P 500, rather than the fund/ETF you use and just adjust positions as if you were following a covered call strategy. The index options are cash settled and get preferential tax treatment 40/60 short/long term capital gains under section 1256 of the Tax code - not bad at all if compared to federal bonds.
From what I've gathered from the outstanding posts here and from research papers, a covered call strategy (at the money or 2% OOM a month out) by itself decreases portfolio volatility, but also decreases annualized return. There is speculation about better risk adjusted returns. Selling cash secured puts for long positions you are happy to own seems to offer lower long term returns instead of just going long in the first place with the cash. So neither on it's own seems to improve returns. However, combining the too seems beneficial, because assuming short durations for your options (e.g. one month out), it is extremely unlikely that stock prices will move unfavorably for you in sequence for both the short put and call positions. I.e. at least one leg expires worthless. And you still profit from selling volatility (you've added a volatility factor/exposure to your portfolio).

Pros: income generation, diversification by adding volatility exposure/returns to the portfolio (which, I believe, is less strongly correlated with stocks, more info here ), favorable tax treatment if using index options, low transaction cost & bid ask spread issues, speculative (see questions): better risk adjusted returns.

Cons: increased downside risk vs vanilla long stock positions; potentially sacrificed upside, deviating a lot more often from the target allocation, margin risk if used; for investors with higher risk tolerance, because of the inclusion of puts.

Questions:
  1. has anyone researched this in mode details? Could you share your takeaway?
  2. anybody who is doing it - could you share experiences?
  3. has anyone seen good info on whether the short strangle improves returns (especially if the options are further OOM, e.g. 10%), since at least one if not both option are likely to expire worthless.
  4. any analysis on how far OOM and what duration to use to improve returns or the risk profile?
  5. is there a better alternative to achieving a similar outcome?
On transaction costs and bid/ask spreads - before this gets brought up as detrimental for returns, bid/ask spreads on S&P500 options are tiny and a single contracts is of large monetary value. If you want to minimize contract cost, SPX can satisfy the needs of most investors with just a single contract, and SPY and XSP-mini should work well too, so I don't perceive this to be something that impacts returns significantly (unlike the management fee of a buy-write fund, for example).
Like another poster said, the issue with some of the covered strangles are the premium, depending on the underlying it might be too much work for few extra pennies. You have to also consider volume on the strikes plus the other Greeks that make up option premium. If you really want to, check out some videos from tastyworks (google them). I have found more success with cash secured puts, covered calls and generally utilizing Short strangles on highly volatile risky trades ( eg NKLA) . Please evaluate your risk before doing anything, you can lose everything in options trying to make a few extra $. There are lots of simulated trading tools where you can test your option strategies before playing with real money.
Topic Author
HomeBarista
Posts: 19
Joined: Sat Sep 29, 2018 7:16 pm

Re: Short covered strangle on your stock allocation

Post by HomeBarista »

countdrak wrote: Wed Sep 16, 2020 5:35 am Like another poster said, the issue with some of the covered strangles are the premium, depending on the underlying it might be too much work for few extra pennies. You have to also consider volume on the strikes plus the other Greeks that make up option premium. If you really want to, check out some videos from tastyworks (google them). I have found more success with cash secured puts, covered calls and generally utilizing Short strangles on highly volatile risky trades ( eg NKLA) . Please evaluate your risk before doing anything, you can lose everything in options trying to make a few extra $. There are lots of simulated trading tools where you can test your option strategies before playing with real money.
You, and the other poster, are summarizing it well. If you want to profit from volatility, look at the volatile stocks, rather than the indices. The issue is that my successes there take a lot of research and analysis, so I'd rather instead focus on my career. I've been looking for a way to generate a bit more "passive" income, with simple rules and minor adjustments based IV and the greeks, etc., rather than to dedicate lots of time on options trading. Som I've been looking for a simple approach that I can apply consistently and doesn't take too much approach on top of my regular portfolio management.

Will do a bit of research on whether the previously outlined plan makes sense based in this environment and update.
Topic Author
HomeBarista
Posts: 19
Joined: Sat Sep 29, 2018 7:16 pm

Re: Short covered strangle on your stock allocation

Post by HomeBarista »

countdrak wrote: Wed Sep 16, 2020 5:35 am Like another poster said, the issue with some of the covered strangles are the premium, depending on the underlying it might be too much work for few extra pennies. You have to also consider volume on the strikes plus the other Greeks that make up option premium. If you really want to, check out some videos from tastyworks (google them). I have found more success with cash secured puts, covered calls and generally utilizing Short strangles on highly volatile risky trades ( eg NKLA) . Please evaluate your risk before doing anything, you can lose everything in options trying to make a few extra $. There are lots of simulated trading tools where you can test your option strategies before playing with real money.
You, and the other poster, are summarizing it well. If you want to profit from volatility, look at the volatile stocks, rather than the indices. The issue is that my successes there take a lot of research and analysis, so I'd rather instead focus on my career. I've been looking for a way to generate a bit more "passive" income, with simple rules and minor adjustments based IV and the greeks, etc., rather than to dedicate lots of time on options trading. So, I've been looking for a simple approach that I can apply consistently and doesn't take too much approach on top of my regular portfolio management.

Will do a bit of research on whether the previously outlined plan makes sense based in this environment and update.
flyingcows
Posts: 126
Joined: Sat Apr 20, 2019 8:13 am

Re: Short covered strangle on your stock allocation

Post by flyingcows »

HomeBarista wrote: Wed Sep 16, 2020 5:56 pm
countdrak wrote: Wed Sep 16, 2020 5:35 am Like another poster said, the issue with some of the covered strangles are the premium, depending on the underlying it might be too much work for few extra pennies. You have to also consider volume on the strikes plus the other Greeks that make up option premium. If you really want to, check out some videos from tastyworks (google them). I have found more success with cash secured puts, covered calls and generally utilizing Short strangles on highly volatile risky trades ( eg NKLA) . Please evaluate your risk before doing anything, you can lose everything in options trying to make a few extra $. There are lots of simulated trading tools where you can test your option strategies before playing with real money.
You, and the other poster, are summarizing it well. If you want to profit from volatility, look at the volatile stocks, rather than the indices. The issue is that my successes there take a lot of research and analysis, so I'd rather instead focus on my career. I've been looking for a way to generate a bit more "passive" income, with simple rules and minor adjustments based IV and the greeks, etc., rather than to dedicate lots of time on options trading. So, I've been looking for a simple approach that I can apply consistently and doesn't take too much approach on top of my regular portfolio management.

Will do a bit of research on whether the previously outlined plan makes sense based in this environment and update.
I've been a net seller of option premium since 2015 and try to keep my approach as mechanical and consistent as possible:

- Always neutral to bullish portfolio direction, never tilted bearish
- Index and ETF options only
- Risk defined strategies only with very wide spread widths
- 30-45 days to expiration for all trades
- I keep buying power utilization at 25-50% with the risk I am willing to take on balanced against my target monthly max return on capital target which is between 1.5-2% a month. I dial up the target when IV percentile/rank is high
- High probability trades, typically use a 15-30 Delta range range
- When I open trades, I also enter a good to close order to automatically close my trades at the target profit percentages (close spreads and wide condors at 50% profit, butterflies at 25%)
- I typically put on new trades every 1-2 weeks, more or less depending on how things have worked out. Again, aligned to my target RoC

It's been pretty manageable for me, an hour or two a week of planning typically
Topic Author
HomeBarista
Posts: 19
Joined: Sat Sep 29, 2018 7:16 pm

Re: Short covered strangle on your stock allocation

Post by HomeBarista »

flyingcows wrote: Wed Sep 16, 2020 9:52 pm I've been a net seller of option premium since 2015 and try to keep my approach as mechanical and consistent as possible:

- Always neutral to bullish portfolio direction, never tilted bearish
- Index and ETF options only
- Risk defined strategies only with very wide spread widths
- 30-45 days to expiration for all trades
- I keep buying power utilization at 25-50% with the risk I am willing to take on balanced against my target monthly max return on capital target which is between 1.5-2% a month. I dial up the target when IV percentile/rank is high
- High probability trades, typically use a 15-30 Delta range range
- When I open trades, I also enter a good to close order to automatically close my trades at the target profit percentages (close spreads and wide condors at 50% profit, butterflies at 25%)
- I typically put on new trades every 1-2 weeks, more or less depending on how things have worked out. Again, aligned to my target RoC

It's been pretty manageable for me, an hour or two a week of planning typically
Thank you for sharing, flyingcows! This sounds very encouraging. This is exactly the type of system I would like to dial in for my portfolio. Additional return, with limited efforts in managing.

Could you kindly share a few more details on your strategy? I would greatly appreciate it and it would help me devise a similar system for myself.

Would love to get your thoughts on these:
  1. What's your approach for selecting which indices or ETFs to trade options on? And which ones do you usually use?
  2. On the very wide spreads
    1. what max profit to max loss ration do you normally target?
    2. given you are trading mostly index / ETF options (I assume high liquidity), and given the wide spreads, and the likely lower volatility of the underlying, have you considered a stop loss instead of the risk limiting leg? Why/why not?
  3. On the good to close order - given options are still a lot less liquid than the underlying, have you noticed if those are always fulfilling exactly at the limit price? Do you feel you are leaving too much money at the table for the market makers?
  4. Have you noticed slightly shorter time to expiration to provide better returns? And if so, is the additional required time commitment the reason not to go for it?
  5. Finally, do you always require your entire order to fullful in a single transaction? I.e. no risk of an unfilled leg.
ChrisBenn
Posts: 422
Joined: Mon Aug 05, 2019 7:56 pm

Re: Short covered strangle on your stock allocation

Post by ChrisBenn »

CBOE released a 4% OTM short strangle index recently

http://www.cboe.com/index/dashboard/SST ... k-overview

The Cboe S&P 500 4% OTM Short Strangle Index (with KRW 3month Certificate of Deposit) (SSTGK) is a benchmark index designed to track the performance of a hypothetical option trading strategy that: (1) sells a rolling monthly 4% Out-of-the-Money (OTM) SPX Put option and a rolling monthly 4% Out-of-the-Money (OTM) SPX Call option and (2) holds a money market account invested in KRW 3 month Certificate of Deposit rate, which is rebalanced on the option Roll Day. All SPX options involved are AM-settled and roll on a monthly basis.

Image


Now the index didn't start until Feb, but that gave it a good crash and recovery. It's about 25% behind plain S&P 500 - still in the red. Which I guess saves you from paying the higher tax rate this year, instead of deferring a lower tax rate:)

Honestly looks very uncompelling. With a lot of the derivative strategies I really like to see them benchmarked against the underlying index when possible, as otherwise one lacks a good way to really evaluate what one is getting back for the higher complexity and worse tax treatment.
Topic Author
HomeBarista
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Re: Short covered strangle on your stock allocation

Post by HomeBarista »

ChrisBenn wrote: Thu Sep 17, 2020 9:27 pm CBOE released a 4% OTM short strangle index recently

http://www.cboe.com/index/dashboard/SST ... k-overview

The Cboe S&P 500 4% OTM Short Strangle Index (with KRW 3month Certificate of Deposit) (SSTGK) is a benchmark index designed to track the performance of a hypothetical option trading strategy that: (1) sells a rolling monthly 4% Out-of-the-Money (OTM) SPX Put option and a rolling monthly 4% Out-of-the-Money (OTM) SPX Call option and (2) holds a money market account invested in KRW 3 month Certificate of Deposit rate, which is rebalanced on the option Roll Day. All SPX options involved are AM-settled and roll on a monthly basis.

Image


Now the index didn't start until Feb, but that gave it a good crash and recovery. It's about 25% behind plain S&P 500 - still in the red. Which I guess saves you from paying the higher tax rate this year, instead of deferring a lower tax rate:)

Honestly looks very uncompelling. With a lot of the derivative strategies I really like to see them benchmarked against the underlying index when possible, as otherwise one lacks a good way to really evaluate what one is getting back for the higher complexity and worse tax treatment.
Oh, this is great. Thank you for sharing, ChrisBenn! I don't know how I missed this.
The CBOE charts confuse me a bit, but I'm expecting that the "performance" graph plots total returns (with reinvestment of dividends and option premium) without accounting for taxes. Please, correct me if I didn't get it right.

Digging more into the various options strategies, CBOE has an excellent comparison piece:
http://www.cboe.com/blogs/options-hub/2 ... ed-returns
Notice how only the OOM buy write 30 delta index (BXMD) outperfoms SPX. Unfortunately, this is before expenses and taxes :(. On the positive side, it has a much lower volatility. The PUT index (put write) also does really well, with comparative performance to the S&P and lower volatility. It also holds a rather large cash reserve (max loss), which adds some performance drag.
In comparison, the short strangle index seems to do worse, and the rather extreme price moves this March destroy its otherwise good performance:

Image

So far, it seems that there may be some value in the put write, buy write, and the strangle, but the likely reality is that the benefits would disappear after taxes and fees (and/or the considerable amount of time to manage it). At least the indices show that most of these don't show higher returns. They may offer higher risk adjusted return, though, which is promising. Will look more into this and keep updating the thread.
ChrisBenn
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Re: Short covered strangle on your stock allocation

Post by ChrisBenn »

HomeBarista wrote: Thu Sep 17, 2020 11:35 pm (...)
So far, it seems that there may be some value in the put write, buy write, and the strangle, but the likely reality is that the benefits would disappear after taxes and fees (and/or the considerable amount of time to manage it). At least the indices show that most of these don't show higher returns. They may offer higher risk adjusted return, though, which is promising. Will look more into this and keep updating the thread.
That was my take on this as well; in general lower returns, but also lower volatility. May or may not be better on a risk adjusted basis, but wouldn't surprise me if it was. But the tax double whammy is rough - stcg mostly, unless you do index options (40% then) - but you are also forced to realize every year.

Some if the strats are doable in a tax advantaged account -- but in those I'm in accumulation and prefer higher total returns to higher risk adjusted (within reason). Now if someone was in deccumulation maybe there was a use case, but not sure.

Invesco has a product, PBP, that tracks the BXM index (https://www.invesco.com/us/financial-pr ... ticker=PBP)

I think this one sells a near the money call options, (while BXMD sells 0.3 delta OTM call options, as you mentioned). So it allows for more upside (at the cost of less premium).

You can look at the tax cost ration for PBP vs VOO.

https://www.schwab.com/public/schwab/in ... axAnalysis
vs
https://www.schwab.com/public/schwab/in ... axAnalysis

5-yr 2.05% tax cost ratio (PBP). vs 0.48% for VOO

So that gives you an idea of the headwind on the strategy.

I definitely find these interesting, but haven't found an options strategy yet that (for investing) seemed to be be the best choice. I do have a potion of my efund in SWAN (treasuries + buy long calls) but I do worry thats more if a bet on having a strongly trending vs flat market (which we have had recently).

It's really the tax situation that is the gotcha.
occambogle
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Re: Short covered strangle on your stock allocation

Post by occambogle »

I'm very much uneducated when it comes to puts and calls, so excuse my ignorance, but is this at all similar to what this SPYC ETF is doing?

viewtopic.php?t=325695
User avatar
wshang
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Re: Short covered strangle on your stock allocation

Post by wshang »

There are a couple of ways to improve your chances of consistently coming on top:

1) Trade index options: There is a special tax law that treats 60% of gains are taxed at longer-term rates, while 40% are taxed at short-term rates. But in this case, it doesn’t matter how long you’ve held the position. Index options are also good because of the narrow bid/ask spreads and large liquidity pools. The data is excellent with SPY SPX options because they are tracked by futures contracts, so you can get a feel how they have been trading prior to market opening and after closing. Downside is they trade until 4:15 and can be exercised until 6PM.

2) Unlike BH's, when using this strategy, I time the market. I am looking for high VIX values to sell put options into. I calculate probable daily ranges based upon straddle pricing.

3) It is possible to calibrate your risk from Delta. If you are going to trade options, you absolutely need to have a deep understanding of the Greeks. Also consider using the "Think or Swim" platform which allows unprecedented programming of orders from timing (on/off, close of market), triggers (underlying, derivatives, anything really). You can't be glued to the computer or cellphone, that's not a life.

4) There are a variety of low-risk options strategy books. I suggest reading at least three: Options as a Strategic Investment, Options Trading: How to Increase Your Income at Low Risk, The Bible of Options Strategies.

5) One more plug for the "Think or Swim" platform. They have a switch which allows you to test your strategy in real time or back test it. This is absolutely key because you need to know what you are going to do in any circumstance after putting on the trade, or likely have your head handed to you.
flaccidsteele
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Location: Canada

Re: Short covered strangle on your stock allocation

Post by flaccidsteele »

For the discount I would need to start buying more, selling OOM puts would get me no premium. And I run the real risk of being called away

It’s like churning the water for pennies

No dice
The US market always recovers. It’s never different this time. Retired in my 40s. Investing is a simple game of rinse and repeat
ChrisBenn
Posts: 422
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Re: Short covered strangle on your stock allocation

Post by ChrisBenn »

occambogle wrote: Fri Sep 18, 2020 7:26 am I'm very much uneducated when it comes to puts and calls, so excuse my ignorance, but is this at all similar to what this SPYC ETF is doing?

viewtopic.php?t=325695
Similar only in that it's using options.
SPYC looks to be 98% S&P 500, 1% long OTM calls, and 1% long OTM puts
Image

When you buy options those options loose value every day you hold them (as opposed to selling them, where you effectively gain value every day they are not exercised). So in a flat market this strat is pretty much guaranteed to loose 2% a year.

This particular combination is called a long strangle: https://www.fidelity.com/learning-cente ... g-strangle

You can see the values SPX would have to move to for the options to break even:
http://opcalc.com/ewH

for the March 2021 offering the put breaks even at about 1780 and the call breaks even at 4420 (at expiration). I'm assuming they roll before that, but didn't see in their docs when they roll the options.

Also realize the options are only 2% (1% put, 1% call) of the fund, so the return you get from them is only on 1% of your portfolio (since only one of them is going to pop (or neither)).

I'm dubious about the utility of this. It feels like buying insurance on your car, but paying less so you cap it to 1% of your cars value. Is it even worth the hassle?
flyingcows
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Re: Short covered strangle on your stock allocation

Post by flyingcows »

HomeBarista wrote: Thu Sep 17, 2020 9:00 pm Thank you for sharing, flyingcows! This sounds very encouraging. This is exactly the type of system I would like to dial in for my portfolio. Additional return, with limited efforts in managing.

Could you kindly share a few more details on your strategy? I would greatly appreciate it and it would help me devise a similar system for myself.
If you are new to options, I would recommend taking your time and starting small, or you could even start out with a paper trading through the Thinkorswim platform. With options and margin, the devil is in the details. There is a book called Options as a Strategic Investment by Lawrence McMillian that is very good, I wouldn't exactly call it a page turner, but at worst it's a useful reference book. If you get it, make sure it's the most recent edition. Also there is a YouTube channel called "Project Option" which you may find helpful, I have only watched a couple of his videos but I think he does an excellent job creating content. The trading platform you use is also important, TD Ameritrade's Thinkorswim platform is very popular, I currently use Schwab StreetSmart Edge but have used ToS previously.
HomeBarista wrote: Thu Sep 17, 2020 9:00 pm Would love to get your thoughts on these:
  1. What's your approach for selecting which indices or ETFs to trade options on? And which ones do you usually use?
The first 2 years I was doing options, I simply used $SPX, $RUT, EFA, and EEM in a static allocation.

Now I use a list of ETFs with high option liquidity and index options that I rank based it's 52 week historical IV percentile and distance from their moving averages (using mean reversion as a decision point for directional assumption). I only use credit spreads and the short strikes I'm selling are somewhere between the midpoint to outter edge of the expected 1 standard deviation move for that period

Code: Select all

$SPX, $RUT, $NDX, SPY, QQQ, IWM, DIA, EFA, EEM, EWZ, EWW, FXI, XLF, XRT, KRE, IYR, SMH, XBI, XLB, XLP, XLU, XOP, EWJ, USO, EWZ, GLD, SLV, TLT
The Index options work differently than ETF options and have some benefits: they are section 1256 contracts, settled to cash, early assignment not possible, and have much larger nominal values than the ETF trackers so that you can use fewer contracts. Though they also have drawbacks: wider bid ask spreads and limited selection.

HomeBarista wrote: Thu Sep 17, 2020 9:00 pm [*] On the very wide spreads
  1. what max profit to max loss ration do you normally target?
My decision process is for the short leg:

1.) What is my target return on capital for this month? For me this is 1.5%-2.0% based on IV percentile of my investment options
2.) How close am I to my target? If I am on track or ahead, I won't put on any new trades
3.) What is my current buying power utilization and what is the RoC for the short leg premium between .15-.30 delta? I will take the lowest delta that will meet monthly RoC target, with a floor of 1.2% RoC over 30 days as the lowest premium I will accept for any individual short leg

For the long leg:

What is the Impact on my available buying power relative to my maximum target buying power utilization (25-50%). Ideally, I want the cost drag as small as possible, < 5%, though there tends to be diminishing returns going further out at some point and a "sweet spot". It also functions as black swan event insurance for the rare big 3+ standard deviation move events
HomeBarista wrote: Thu Sep 17, 2020 9:00 pm [*] given you are trading mostly index / ETF options (I assume high liquidity), and given the wide spreads, and the likely lower volatility of the underlying, have you considered a stop loss instead of the risk limiting leg? Why/why not? [/list]
If you do undefined risk trades you will have higher initial margin requirements, the exact formula and rules will be brokerage specific but initial requirement is about 20% of the underlying with a standard margin account (less if you have a portfolio margin account). Then as your position moves against you, the Margin requirement will increase. A stop loss could also trigger at anytime, if you don't react accordingly you may miss out on the upside.

With risk defined trades, you will use much less buying power. Yes, you do have the drag of the long leg but you don't have margin expansion. (Yes, there is still the slight possibility of early assignment even with a spread).
HomeBarista wrote: Thu Sep 17, 2020 9:00 pm [*] On the good to close order - given options are still a lot less liquid than the underlying, have you noticed if those are always fulfilling exactly at the limit price? Do you feel you are leaving too much money at the table for the market makers?
I put in a good to close limit order for a fixed amount, it either gets filled at that amount or it remains open. Now, in some cases the long legs will not be worth closing from a cost perspective if they only cost pennies, in these cases I will enter the closer order for the short legs only and let the long legs expire worthless.
HomeBarista wrote: Thu Sep 17, 2020 9:00 pm [*] Have you noticed slightly shorter time to expiration to provide better returns? And if so, is the additional required time commitment the reason not to go for it?
Yes In general, shorter duration options will have a more favorable Theta, Theta decay also accelerates the closer you get to expiration. You can see this graphed on brokerage platforms to get a good visualization. So all else being equal, 4 weekly options would yield more premium than 1 monthly option assuming all expired worthless, the downside of shorter duration is that you are accepting risk of assignment for less premium per contract. I like the risk reward of 30-45 days
HomeBarista wrote: Thu Sep 17, 2020 9:00 pm [*] Finally, do you always require your entire order to fullful in a single transaction? I.e. no risk of an unfilled leg.
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Yes
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