Smooth Sailing With Options

SmoothSailing#19

TastyTrade likes to recommend selling options with 42 days to expiration, (DTE) then rolling them around 21 DTE.  Supposedly this captures some of the theta decay, which is just fancy talk for time value, and avoids most gamma volatility.  (Gamma is merely the first derivative of delta, df(x)/dx.  Way, way more information than we need.) 

So, of course, I’ve been trading some of those.  What I’m finding is that the time decay is too small in that first 21 days, so that the premium/profit level is way too small.  As we know, the shorter the contract the more per day we get paid in premium.  This method does just about the opposite by staying 21 days out minimum at all times, reducing the per day amount significantly.  And besides, gamma is irrelevant if you don’t care about getting assigned, which typically we don’t, and gamma is also irrelevant when you know how to properly manage a position on expiration day.  Gamma is irrelevant to us, period.  Even with this 42-21 day set-up, if the stock moves enough you can still get blown out and have to manage it just like you do with short contracts, however the remaining time value in the 21 day trade makes it harder to roll out successfully.

So screw TastyTrade.  They like to talk fancy and make lots of videos, but I don’t buy it.  It really amazes me to read all these option trading sites and follow the Reddit trading gangs and see self-imposed but needless complexity and these vain attempts to chase complex trading strategies that just don’t work.  Simple is better.

Complex investments exist only to profit those who create and sell them. Not only are they more costly to the investor, they are less effective.”

-JL Collins

Smooth Sailing With Options

SmoothSailing#18

When I wrote “Smooth Sailing with Options”, I tried to talk a little bit about the fact that the ways we think about money is perhaps more important than trying to apply technical skills.  The big firms with their quants lose money too, as do the traders who live by technical/fundamental indicators and who follow the latest news on CNBC.  I wrote about research that showed that the distribution of returns for stocks demonstrates that something like 40% of all stocks lost at least 70% of their value and never recover, and that only 7% of stocks actually generate the returns that lift the entire index.  I said that if the quants and the experts can’t find that 7%, why should we, as small traders, even try?  We shouldn’t, which is why we’re better off selling options on etfs.  (Or, for non-trading investors, just owning a few well-chosen Vanguard funds) I’ve always thought that the soft skills are more important than the hard (technical) skills.  It’s more important to make better financial decisions than it is to spend hours trying to analyze fundamentals or technical indicators.  Soft skills means things like living below your means and saving the extra, downsizing the huge house, paying attention to the numerous and small things that bleed away funds every month, that list is endless.  Most people pay zero attention to any of it, or they are masters at justifying why they continue to make those decisions.  (Like pets.  People spend fortunes on pets and wow, are they adamant in their justification!) Managing our emotions and biases about money may be more difficult than managing our trading positions.

At least, that was my theory, based on simple observation, and confirmation from a few books and a few like-minded people like Mr Money Moustache, all very informal. 

However, I just read a book that backs me up with research.  Quote from the back page:
“Money – investing, personal finance, and business decisions – is typically taught as a math-based field, where data and formulas tell us exactly what to do. But in the real world people don’t make financial decisions on a spreadsheet.  They make them at the dinner table, in a meeting room, where personal history, your own unique view of the world, ego, pride, marketing and odd incentives are scrambled together.”

The author, Morgan Housel, says that how you behave is more important than what you know.  Sherlock Holmes said “The world is full of obvious things which nobody by any means ever observes.”

Ah, yep, that’s what I see.  So anyway, I have to recommend this book, it’s easy to read, interesting, and I really like his viewpoint.

https://www.amazon.com/Psychology-Money-hardback-Timeless-happiness/dp/0857199099/ref=tmm_hrd_swatch_0?_encoding=UTF8&qid=1660773770&sr=8-1

Smooth Sailing With Options

SmoothSailing#17

A cautionary tale.  I have this book in my collection, “The Complete Guide to Option Selling” by James Cordier.  I recommend it in my book, “Smooth Sailing”.  Still do, in that it does teach the ins and outs of option selling.  However…
James got carried away.  He collected about 300 clients and some $150 million and was selling calls on natural gas, far out of the money at like .2 or .1 delta, so 80 or 90% POS.  All well and good, right?  The premium was rolling in.  But he was selling them on margin.  Borrowed money.  Leverage.  And when natural gas spiked, those margins were called, and poof.  $150 million went up in smoke.  If he had bought the stock and sold those calls like we do, secured calls, it would have not happened.  But he got greedy.
This happened in 2018, and somehow I just heard about it.  On page 33 of my book I warn twice NOT to ever use any margin.  I guess instead of my reading his book, maybe he should have read mine.

https://financialpost.com/investing/wiped-out-hedge-fund-manager-confessed-his-losses-on-youtube


https://www.tampabay.com/business/how-tampas-james-cordier-went-from-high-roller-to-youtube-apology-after-losing-150-million-20190206/

Smooth Sailing With Options

SmoothSailing#16

In an attempt to learn and improve my trading, I signed up for the Blue Collar Investor subscription service for a while and paper-traded his recommendations.  He, Alan Ellman, uses technical and fundamental analysis using screens set up to filter stocks for ones that are moving in the right direction.  My conclusion is, that gives you about a 50% success rate.  Over the few weeks I did this, on average half of his picks did as expected, half cratered.  So I still don’t see any advantage to overly relying on technical analysis or on using individual stocks.  My analysis is not professional and certainly not rigidly scientific and I only did it for a few weeks, so it’s not going to convince a statistician, but it reinforces my original conclusions.  ETFs are the way to go when selling options.

Full disclosure:  I experiment a bit so I do own some individual stock, some DIS and some AMZN, the result of selling puts and put spreads.  Both are severely underwater, even though when I got into them they had great fundamental and technical numbers.  Sheesh.  I need to continue working on my voodoo skills there. 

Smooth Sailing With Options

SmoothSailing#15

I’m still learning as new things develop.  I got hit with a trading violation for 90 days a while back for trading with “uncleared funds”.  When you sell an option it takes one day, overnight, for the funds to clear so that you can use those funds again.  When you sell a stock it takes two days for the funds to clear.  Back when IWM traded weekly we didn’t have to worry about funds clearing since the weekend gave them plenty of time to clear.  When IWM started expiring three times a week I got caught out by getting assigned on a Wednesday, and, thinking I now had access to my cash, placing another trade on Thursday morning.  With all the market volatility I had also sold calls in the morning and bought them back in the afternoon a few times.  Do that three times and they slap a trading violation on you.  That means I can’t use any uncleared funds.  They will let you do it a few times, but do it too much and you get busted.  This is Federal law, not Fidelity or Schwab’s rules.  It also turns out the restrictions are different for a taxable account and a tax-protected account, and I was trading them both the same.

So, how to avoid this problem?

When you place a trade, pay attention to any messages that say anything about “funds available to trade”.  You can also look at your account balances and you’ll see “funds available to trade” and that’s what you can work with.  When in doubt call ’em and make sure your trade is ok to place.  And of course absolutely do not use margin loans for trading, you never want to borrow money to trade.  If you get margin they will let you but if you screw up you will be in deep hurt.
The question is, how did we do rolls before without bumping into this?  When you do a roll you buy one contract using the uncleared cash from selling the next one.  I’m not sure, and the Fidelity guy couldn’t explain it to me.  I ‘think’ rolls are ok, in my case I was just trading too frequently in my 401K and the trading violation meant I was restricted, but I didn’t know that so I kept trading.  That’s what triggered my violation.

In my case, to get around this, I got margin on my taxable account.  So now when I place a same-day trade, in effect they loan me the money to do the second half of the trade. Then overnight the funds clear and the loan disappears.  I can’t borrow more than whatever I’m selling, but this allows me to trade without bumping into the restrictions.  In my tax-protected account, a roll over 401K, the laws are different there and I was only able to get limited margin, which is a technicality but basically does the same thing.
I’m back in business.

So, how to avoid this problem?
When you place a trade, pay attention to any messages that say anything about “funds available to trade”.  You can also look at your account balances and you’ll see “funds available to trade” and that’s what you can work with.  When in doubt call ’em and make sure your trade is ok to place.  And of course absolutely do not use margin loans for trading, you never want to borrow money to trade.  If you get margin they will let you but if you screw up you will be in deep hurt.
The question is, how did we do rolls before without bumping into this?  When you do a roll you buy one contract using the uncleared cash from selling the next one.  I’m not sure, and the Fidelity guy couldn’t explain it to me.  I ‘think’ rolls are ok, in my case I was just trading too frequently in my 401K and the trading violation meant I was restricted, but I didn’t know that so I kept trading.  That’s what triggered my violation.

In my case, to get around this, I got margin on my taxable account.  So now when I place a same-day trade, in effect they loan me the money to do the second half of the trade. Then overnight the funds clear and the loan disappears.  I can’t borrow more than whatever I’m selling, but this allows me to trade without bumping into the restrictions.  In my tax-protected account, a roll over 401K, the laws are different there and I was only able to get limited margin there, which is a technicality but basically does the same thing.
My trading restrictions fall off on Monday, and now I’ve got margin set up on everything, so I’m back in business.

Smooth Sailing With Options

SmoothSailing#14

When selling options there are only two types of option we can sell, puts and calls. There are only two ways the trade can go, above your strike or below your strike. So here’s a flow chart that strips it down to the very basics. This doesn’t say anything about managing positions early in the contract or the many choices near expiration, that’s all in the book. This is just the first steps of the dance. Hope it’s helpful!

Smooth Sailing With Options

SmoothSailing#13

I’ve been doing this options thing a long time, and I’ve had my failures. But I’m a firm believer in the method and so I want to share a failure with you and how it ended up.

Back in December 2020 I started selling puts on DIS. (Left hand green arrow on the chart)

But I had been selling calls since I was assigned. So today I went back and added all that premium up. I did not add the puts I had sold previous to getting assigned so actually my numbers are slightly better than these calculations, but this is close enough.

All those calls, and I was fortunate that none of them were assigned underwater, added up to $65.80 worth of premium. So my original $190 cost basis was reduced to $124.20. DIS earnings came out after close today, February 9th 2022, and they were good so DIS went up after hours about 7% to $157.45. (Yes the chart says $147.23 but that is the 4PM close price.)

So now I’m back in the green. $157.45 is 26.7% above $124.20. So while it took me a year of working it, and my stock is still down $32.55, if I closed out tomorrow at $157.45 I’d be up 26.7% for that year.

That, I think, is the beauty of what we’re doing and why selling options is the bomb.

Also, spring is coming, again, so maybe Disneyland and the cruise ships will actually pick up. Price targets on DIS are back up to around $170-$190. So with any luck there is more profit to be made here.

Happy trading!

Smooth Sailing With Options

SmoothSailing#12

(This blog is now obsolete, as VXX has been “delisted” by Barclays. However there are other inverse etns out there such as UVIX that would work with this method. -January 2021)

Ok this goes against my normal preaching, (always selling, never buying options) but now that you are a salty and well-experienced option trader, you might want to take a look at the next level. I’m now going to talk about buying options instead of selling them. I’m still selling them as my main income stream, but when I have some extra cash and the situation is right, I buy.

Some background. VXX is the security I use when I buy options. VXX is an ETN, not an ETF like IWM or SPY. Exchange-traded notes (ETNs) are types of unsecured debt securities that track an underlying index of securities and trade on a major exchange like a stock. ETNs are similar to bonds but do not have interest payments. Instead, the prices of ETNs fluctuate like stocks. They are tradeable and some have options.

VXX, the Barclays iPath Series B S&P 500 VIX Short Term Futures ETN, tracks VIX. VIX is the ticker symbol and the name for the Chicago Board Options Exchange’s Volatility Index, a measure of the stock market’s expectation of volatility based on S&P 500 index options. You can’t trade VIX directly, so I use VXX.

Do I care about all that? Nah. Just know VXX is a high-volume high-volatility ticker for trading short-term options.

VXX, since it tracks expected volatility, usually sees explosive moves when the S&P 500 declines. The moves in VXX typically far exceed the movement seen in the S&P 500. For example, a 5% drop in the S&P 500 may result in a 15% – 20% gain in VXX. That means when the stock market drops 900 points in one day, VXX goes through the roof.

VXX also has backwardation after a spike. That’s a fancy stock market term which means the financial instrument in question is expected or designed to go down over time. When market volatility increases dramatically during a correction, it is expected that it will return to normal in the future. That’s backwardation. That means that it is expected that VXX will go back down once the correction is over. And this is, indeed, precisely what happens.

So what does all this mean? It means that when the market tanks, VXX shoots up. At that point I buy to open puts on VXX at or near the money. When VXX inevitably retreats, those puts then go far into the money and are now worth more than I paid for them.

When I buy these puts I buy them out about four months. That gives me three months for the market to recover, which statistically is almost always does, before the time value begins to erode on me. And all I need is one good day, one of those days when the market pops up 600 points. In three months, you know that’s going to happen sometime. That pushes my puts into the money far enough that I can sell to close at a nice profit.

This last go-round of market volatility was a good example of how this works. Starting Friday, November 26th, the market dropped, bounced back Monday, dropped again Tuesday and then recovered once again on Wednesday.

I bought puts on VXX on Friday at the money, sold them for 12.6% gain on Monday, bought them again on Tuesday and sold them this morning, Wednesday December 1st, for another 14.2% gain.

I’ve made my weekly goal just with VXX this week, not even counting my normal IWM calls and puts that I have out. This doesn’t happen all the time, but it does happen three or four times a year.

Check out this chart.

You’ll see my fancy green arrows, one at each date when the market took a hit. Each time VXX spiked, then recovered, usually pretty quickly. I bought puts on each of these and sold them within a day or two at a minimum of 10%. gain. 10% is my goal, and if you wanted to hold these a few weeks longer, you could probably hit 20% with some regularity, but I figure 10% in one week or less is PDG. (New SmoothSailing technical nomenclature: PDG is Pretty Damn Good.)

This would not work as well on anything but VXX, since it has to go down once we buy the options. You can guess market direction all you like with stocks, technical indicators and market news but VXX is based on volatility. It over-reacts when we have a correction and, unless an asteroid strike or the zombie apocalypse occurs, volatility is going to go back down. Since either of those would negate any stock market holdings we might have anyway, it seems like a good trade to me.

You will need to sell these to get out with a profit, so it does take some action. You have to sell to close when you are happy with your gains. If for some reason things go against you, you will want to sell and get out before you take too much of a hit. Maybe set an eight percent loss strategy and get out then. Don’t buy VXX puts except when the market is correcting and VXX is spiking. You have to be sitting at your computer to place the order as you watch the market, a few hours can mean the difference between a good trade and a sketchy one. I actually buy at several different strikes to ride the climb if needed. Friday, for example, I bought puts at the $23 strike, then a little later in the day, as VXX kept going up and the market kept going down, I bought $24 and then $25 strikes. I think it finally hit $29 but I was out of money. You just don’t know how high it’s going to go. You also don’t know how low it will go, so set your profit level and be happy with that. Waiting too long can be a mistake.

I’ve had good luck with this for several years, and only had to get out at a loss when I got too greedy. In fact, this week, I had some DIS that was way underwater. I sold it Friday, used those funds to do all this VXX put buying, made that 26.8% gain in a few days, and now I’m back in cash and so bought the DIS right back.

So there you have it, another tool for your toolbox.

Any questions just ask!

Smooth Sailing With Options

SmoothSailing#11

Now that IWM has three expirations per week, the question is, do we make more money by selling two or three day contracts twice a week or one, one week contract? Once again, in my endless pursuit of options trading excellence, I have spent several hours trying to answer this question and I think I have an answer. I looked at put options chains, comparing returns at different strikes for different time periods. It turns out that the short answer is, yes. When you sell shorter, two or three day put contracts at or near the money, they do indeed pay a little better cumulatively or per day than going out a week. Two short contracts pays more than one long contract. If you look at the number of days in the contract divided by the premium paid, you get the per day return. That difference was consistently anywhere from a couple of pennies per day to twenty cents, depending on how close or far away you are from the money.

You gain a little nimbleness in the shorter trades, since the time frame is shorter. IWM won’t move as much in two days as it might in a week. It also means you have to trade more often, which means more time sitting in front of the computer. Maybe not something desirable. It also takes more time just to figure it out each time. So if you’re willing to put in more time and more trades, there is a slight edge to gain in selling short two-three day puts over one week contracts. I think I’ll do short term contracts when I have time and the difference is worthwhile, otherwise, I’ll just sell out a week like usual.

Covered calls followed the same pattern. For two-three day contracts, more premium per day when close to the money.

Smooth Sailing With Options

SmoothSailing#10

When you sell an option on Friday for the next Friday, you’re looking for seven days of time value in your premium. But when/where does the time value for the two days of the weekend go? Are they discounted by Monday or on Monday? Since I didn’t know, long ago I experimented with selling options on Friday and holding back some, then comparing both sides on Monday to see if there was any difference, once you discounted any stock price movement. As far as I could tell there was very little difference. So this week I did some digging and I did find an explanation on the NASDAQ site. It turns out that yes, there are seven days of time value over the week Friday to Friday, even though the market is open only five days. Importantly for us, however, the market makers (the clearing agencies, about twenty of them) discount the weekend time value on Friday, not Monday, and sometimes even late Thursday, although that is rare. So that means if you’re going to roll out a week, Thursday is the day to do it. Once you get into Friday, you’ve already lost most of the time value for the weekend. Since anything can happen over the weekend, it’s probably better to just let your positions expire Friday and sell again on Monday. You don’t lose any time value premium but you do jump over the weekend, reducing your risk.

I did not know this. I’ve been rolling on Fridays, thinking I was getting that time value. But I confirmed this and my experimental trading shows the same thing, so when it works out, I’m going to try and get my rolling done on Thursdays.