Anyone sell options for retirement income?

[dignam]

Title - I'm still around 10 years from FIRE, but thinking of the choices I have for income down the road.

I've been dabbling a bit with covered call writing and cash covered put writing.  I feel like I'm getting a better understanding of when to use these.  The "wheel" strategy is one I've seen pretty decent returns with in my limited experience.  Basically you start off writing puts on a stock you wouldn't mind owning if you end up getting assigned the shares.  Usually it doesn't get to that point, as you'd want to roll or let the contract expire and just collect the premium.  If you get assigned, you write covered calls until the share price gets to a point where you'd sell the underlying stock and start over.

Anyway, anyone use this method in FIRE?  Is it exclusively what you use? Use it on ETFs or different individual stocks?

[vand]

has been discussed before.

There is not free lunch in writing options.

Yes, you will pick up some fairly regular income from unexcercised options most of the time, but also ocassionally you'll have to sell your shares when the market has a big move and someone exercises those options you sold them. Then you are out of the market for good.

The options market is FAR too efficient to be offering a risk-free premium to option writers.

[dignam]

Yes I understand there are risks, I'm asking if people here actually do it.

[tarheeldan]

There are people, maybe they'll chime in


But like the above poster said,  it's picking up pennies in front of a steamroller

Don't forget to factor in opportunity cost

[vand]

There are people, maybe they'll chime in


But like the above poster said,  it's picking up pennies in front of a steamroller

Don't forget to factor in opportunity cost

Picking up pennies in front of a steamroller is not the right analogy.. that would be writing naked puts or calls without owning the underlying.

Rather, writing covered calls can be thought of as rolling forward the income from a future move where you have set a predetermined sell price. The danger is that you miss out on a big move when the market trends strongly up.   Supposed you had started following this strategy last summer.. you'd probably have been completely forced out of your position a long time ago as the markets moved higher and higher.

[tarheeldan]

Picking up pennies in front of a steamroller is not the right analogy.. that would be writing naked puts or calls without owning the underlying.

I agree that this is a *better* analogy for writing naked options

Rather, writing covered calls can be thought of as rolling forward the income from a future move where you have set a predetermined sell price. The danger is that you miss out on a big move when the market trends strongly up.   Supposed you had started following this strategy last summer.. you'd probably have been completely forced out of your position a long time ago as the markets moved higher and higher.

That's exactly what I meant by:

Don't forget to factor in opportunity cost

And, because this is a much bigger factor relative to the premium income, I still like the steamroller analogy :)

[Financial.Velociraptor]

@dignam

I used the "wheel" strategy for years (I'm a little over 8 years into FIRE).  The highest premiums are only available on the riskiest stocks.  If it looks to good to be true it probably is.  You can however do well on various "blue chip" names.  Recommended sticking to the Dividend Aristocrats list for a beginner.  In the current market, you can earn 30% annualized on "safe" names.  That is an unusual situation and you'll expect to earn closer to 9-12% annualized in low volatility markets.  The CBOE did a study some years ago that found writing covered calls 2% out of the money beat the index (by a sliver) over decades.  It can be quite a bit of work though.  I've simplified the process for myself over the years and it goes pretty fast but it will be time consuming when you start.  It is something you do because you enjoy it, not because it is the easiest way to earn money.

I funded my ER with short calls and puts.  Currently, I see the market as very risky and I don't want to hold a lot of things that don't have a good and safe yield (those two are hard to find together right now!)  So, I'm doing in the money spreads on Dividend Aristocrats.  Most of these are bear put spreads.  The idea is I can make money so long as my blue chips don't rocket away at 7%+ over the one to two month holding period AND my returns accelerate when the inevitable market crash happens.  The 'wheel' strategy will leave you holding a lot of equity that is declining in value during a downturn.  Then, writing covered calls at a strike that makes it worth while, would result in booking a permanent loss if called.   

I'm available for more discussion including by PM if you like but I'm not a licensed advisor and can't offer any individualized advice.

[dignam]

^That makes sense - my thought was to start the "wheel" by writing puts on blue chip names (like Coca Cola for example).

I just looked at the Dividend Aristocrats list, and it appears KO fits that bill.   I hadn't considered that you could book a loss if you get to the covered call part of the strategy and the stock shoots up and the option is exercised.  Maybe that could be mitigated by selling way OTM covered calls until the dividend date but then your premium is tiny.  Or, being more conservative with the put writing so that it's unlikely those will ever be exercised.

Thanks for info - it's definitely fun (albeit time consuming right now) to get the hang of it.  I have years to figure out if it's something I want to use when I RE.

[bacchi]

There's a study out there that I can no longer find that examines a CC strategy but the results are as you would expect.

* In a lackluster/slowly upward market, it works great. Sell next month's call over and over and never get called.
* In a fast charging market, you end up losing your stock and then have to buy back in (i.e., it would've been better to b&h).
* In a declining market, the first 1 or 2 calls work and then it's useless.

I write credit spreads on indices (futures and ETFs).

[hodedofome]

Option selling is great. You look like a genius for years. Then you lose all the money you ever made in 1 month.

[specialkayme]

I'm available for more discussion including by PM if you like but I'm not a licensed advisor and can't offer any individualized advice.

I would highly recommend taking FV up on his offer. He's helped me grow as an investor immensely.

His advice in this instance is also very sound. Starting out with the "wheel" strategy on aristocrat dividend stocks is a fantastic way to learn how to play the options game. I know, because that's largely what I did.

"Wheeling" is a great way to learn, and you make decent returns, but if you make a bad move it can take you a while to get back to "zero." Most of the articles and reddit posts make it sound like you just print cash. Not so much, at least not all the time. I sold a cash secured put on CVX a few years back, and CVX dropped. No big deal, started selling CC on it. But the premiums sucked. Six months later I was still in the hole 15%, and it looked like it would take me another 3 years to get it back. I sold for a loss and moved on. But overall I've made good money on the strategy. TGT has treated me well. T and VZ as well.

But like the above poster said,  it's picking up pennies in front of a steamroller

You hear this alot when people mention writing naked puts, cash secured or otherwise. You don't hear this mentioned as frequently when someone mentions writing CC. Even though their profitability graphs are identical. I always find that interesting.

It's all about probability of success, average gain, and average loss. Because you can calculate the average gain fairly easily, but you can't calculate the average loss easily, and your probability of success is at best a guess, it looks scary and risky. And it is. But so is most types of investing. But if you do some research you can find a good, highly probable option writing strategy, with good backtesting data. The backtesting data isn't flawless, so take it with a grain of salt, but it should lead you early to a conclusion of whether a strategy is viable or not. Allocate a small percentage of your investment funds to the strategy and try it out for a few months. You'll get a better idea of your profitability percentage, and your average gain. Then assume a stock market crash happens and calculate your potential losses. See if it still makes sense. It's easier to do this on indexes. KO is not likely to go to zero tomorrow, but more likely than SPY. SPY won't drop 30% tomorrow (circuit breakers), but KO could (even if it's incredibly unlikely).

Option selling is great. You look like a genius for years. Then you lose all the money you ever made in 1 month.

To each their own, but I think this is a fairly poor view on the entire strategy of "option selling." Some do it for income, some do it for protection, some do it to equalize out returns. Not all are bad strategies. I wouldn't even call any one of them a bad strategy, they just come with different risk profiles.

But, to answer the original question, there are a few using options as FIRE income. A few examples (beyond FV) are:
https://earlyretirementnow.com/2016/09/28/passive-income-through-option-writing-part1/ (really worth the read, in my opinion)
https://spintwig.com/ (less blog style, more backtest style, but great info)

[ChpBstrd]

I'm still around 10 years from FIRE, but thinking of the choices I have for income down the road.

This is an error I made years ago. If you have a decade to go until FIRE, you don't need to be locking in low returns on bonds, chasing dividend mirages, day-trading for income, or, as I would argue, even selling covered calls. You need to lock in buy-and-hold positions that will experience compound growth for a decade and focus on your career. You do not need "income investments" while you have a job, and you arguably don't need them afterwards either, but that's another story.

My credentials to know this stuff? Would be retired right now instead of 3 years to go had I thought this way just 4-5 years ago. Shoulda just bought the indexes.

The options market is the efficient market hypothesis written into computer code, and you are trading against supercomputers, who represent "the casino". As at the roulette table, you can select your own odds, but the computer will never pay you more than your option is worth, or let you buy an option for less. There is an invisible "house cut" hidden in the bid-ask spread, and in options trading the price of diversification is to pay that cut thousands of times.

The interesting thing about taking options risk is its interaction with taking long stock risk. You can hedge your 90% stock position with long puts and have a portfolio safer than bonds, but with way more upside. You can sell puts to enter a position and have a chance at winning that gamble (or getting left in the dust).

I sell covered calls around the 0.10 delta in an attempt to eek out a series of small wins, but in the past I've lost more stock appreciation than I've won in premiums, so it's far from easy money.

My recommendation if you're still interested: Spend a couple of years paper-trading.

[Rob_bob]

Option selling is great. You look like a genius for years. Then you lose all the money you ever made in 1 month.
[/quote
Can you give an example?  Are you talking about the loss of potential capital gains, or are you talking about the actual loss of premium dollars collected?

[dignam]

Thanks for the additional info - I have actually already read through that ERN description of option writing which clearly explains what's at risk depending on what sort of options you're writing.  It was a good read.  I'll play around with that backtesting site though. 

[dignam]

I'm still around 10 years from FIRE, but thinking of the choices I have for income down the road.

This is an error I made years ago. If you have a decade to go until FIRE, you don't need to be locking in low returns on bonds, chasing dividend mirages, day-trading for income, or, as I would argue, even selling covered calls. You need to lock in buy-and-hold positions that will experience compound growth for a decade and focus on your career. You do not need "income investments" while you have a job, and you arguably don't need them afterwards either, but that's another story.

My credentials to know this stuff? Would be retired right now instead of 3 years to go had I thought this way just 4-5 years ago. Shoulda just bought the indexes.

The options market is the efficient market hypothesis written into computer code, and you are trading against supercomputers, who represent "the casino". As at the roulette table, you can select your own odds, but the computer will never pay you more than your option is worth, or let you buy an option for less. There is an invisible "house cut" hidden in the bid-ask spread, and in options trading the price of diversification is to pay that cut thousands of times.

The interesting thing about taking options risk is its interaction with taking long stock risk. You can hedge your 90% stock position with long puts and have a portfolio safer than bonds, but with way more upside. You can sell puts to enter a position and have a chance at winning that gamble (or getting left in the dust).

I sell covered calls around the 0.10 delta in an attempt to eek out a series of small wins, but in the past I've lost more stock appreciation than I've won in premiums, so it's far from easy money.

My recommendation if you're still interested: Spend a couple of years paper-trading.

To clarify - my current strategy is buy and hold S&P 500 index funds.  That's it.  I have about 1-2% of my NW in a brokerage playing around with stocks trying to learn what choices I have.  I just want to be "fluent" when I FIRE.

[bacchi]

But, to answer the original question, there are a few using options as FIRE income. A few examples (beyond FV) are:
https://earlyretirementnow.com/2016/09/28/passive-income-through-option-writing-part1/ (really worth the read, in my opinion)

Taxes.

$1.00 invested on June 30, 1986, would have grown to $16.42 by January 29, 2016, if using the option writing strategy. Investing in the S&P500 your portfolio would have grown to only $14.83 (dividends reinvested). Despite selling the equity upside, writing puts would have returned more than the equity index. That’s how overpriced put options are. We say it again: it’s legalized highway robbery!

Taxes (STCG or even 1256 treatment) would chew up and spit out that 10.7% gain over 30 years. This strategy is not better in a brokerage account than b&h.

[specialkayme]

$1.00 invested on June 30, 1986, would have grown to $16.42 by January 29, 2016, if using the option writing strategy. Investing in the S&P500 your portfolio would have grown to only $14.83 (dividends reinvested). Despite selling the equity upside, writing puts would have returned more than the equity index. That’s how overpriced put options are. We say it again: it’s legalized highway robbery!

Taxes (STCG or even 1256 treatment) would chew up and spit out that 10.7% gain over 30 years. This strategy is not better in a brokerage account than b&h.

I'm not sure I'm willing to come to the same conclusion. For one, it produced lower volatility over b&h, about 1/3rd less. If you're looking for a consistent income stream, the option writing strategy may provide more consistency than b&h. Wealth generation may be a different story though. For two, depending on the backtest you use and the time period in question, the difference could be much larger:
https://earlyretirementnow.com/2020/06/17/passive-income-through-option-writing-part-5/ (a two year backtest)

The option strategy in some situations could produce twice or more the return of b&h on the SPY. $100k in b&h would produce $105k after 2 years. If the option strategy produced $110k, and I had to pay 22% taxes on the $10k gain, I'd end up with $108k. Still better off.

That doesn't include the income generated from the collateral securing the strategy. Muni bonds produced 5% per year. Over that 2 year period, $100k would have generated an additional $10k, tax free, putting your returns closer to $118k, after taxes. Much better than the $105k in b&h.

But that's why backtesting is so difficult to put value on. A two year window in one situation might show a slight advantage to options, a 10 year window might show a slight advantage to b&h. It all depends on the overall picture. Almost all show a reduction in volatility, without much of a sacrifice (if any) compared to b&h. But YMMV.

[bacchi]

$1.00 invested on June 30, 1986, would have grown to $16.42 by January 29, 2016, if using the option writing strategy. Investing in the S&P500 your portfolio would have grown to only $14.83 (dividends reinvested). Despite selling the equity upside, writing puts would have returned more than the equity index. That’s how overpriced put options are. We say it again: it’s legalized highway robbery!

Taxes (STCG or even 1256 treatment) would chew up and spit out that 10.7% gain over 30 years. This strategy is not better in a brokerage account than b&h.

I'm not sure I'm willing to come to the same conclusion. For one, it produced lower volatility over b&h, about 1/3rd less. If you're looking for a consistent income stream, the option writing strategy may provide more consistency than b&h. Wealth generation may be a different story though. For two, depending on the backtest you use and the time period in question, the difference could be much larger:
https://earlyretirementnow.com/2020/06/17/passive-income-through-option-writing-part-5/ (a two year backtest)

The option strategy in some situations could produce twice or more the return of b&h on the SPY. $100k in b&h would produce $105k after 2 years. If the option strategy produced $110k, and I had to pay 22% taxes on the $10k gain, I'd end up with $108k. Still better off.

That doesn't include the income generated from the collateral securing the strategy. Muni bonds produced 5% per year. Over that 2 year period, $100k would have generated an additional $10k, tax free, putting your returns closer to $118k, after taxes. Much better than the $105k in b&h.

But that's why backtesting is so difficult to put value on. A two year window in one situation might show a slight advantage to options, a 10 year window might show a slight advantage to b&h. It all depends on the overall picture. Almost all show a reduction in volatility, without much of a sacrifice (if any) compared to b&h. But YMMV.

Yeah, a better back test is needed than an, ahem, 2018-2020 one (you should see my 3 week long r/WSB FOMO back test :-).

The 1988-2011 performance shows that B&H is marginally better in a taxable account at 22%.*

The 2006-2015 PUT/WPUT performance has poorer absolute returns than B&H. **

The 1986-2015 PUT/WPUT out performance is barely existent. ***

The PUT strategy includes holding treasuries; holding munis might juice the returns a bit but the broker may not give them the same performance bond value. I.e., treasuries are the same as cash. Anyone hold muni bonds in a margin account?

These strategies do have lower draw downs****, which would be valuable for SORR. It'd be interesting to see the returns on a PUT strategy that converts to a B&H strategy after the first major decline.


* https://cdn.cboe.com/resources/indices/documents/pap-assetconsultinggroup-cboe-feb2012.pdf
** https://www.cxoadvisory.com/equity-options/performance-of-cboe-putwrite-indexes/
*** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2750188
**** https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2750188 "The maximum drawdowns were 24.2 percent for the WPUT Index, 32.7 percent for the PUT Index and 50.9 percent for the S&P 500 Index. "

[bacchi]

The PUTW ETF had the same % decline as VTI during the covid panic. ??? It's also been seriously outpaced since inception in 2016 (106% to 16%).

We've been in a rising market and so it comes down to market timing.

[park10]

---- Been doing this on Index etfs $SPY and $QQQ for couple years now with good results. this is the reason i changed every index investment from Vanguard etfs to $SPY $QQQ. Basic strategy is simple:  30 delta calls 20 delta puts 40 days out expect 1% income on both sides. If ITM, and Roll Continuous forward roll, almost always for credit or breakeven.

---- In raging bull mkts If you dont want to let go of the shares, then selling only calls may not work well, as your short call gets deep ITM quick and you are not able to roll fast enough. Worst case you can go for months at a time without any additional income (but still not a loss).
---- Writing puts along with calls (covered strangles) is what makes this strategy work exceptionally well. Even if short call is ITM due to mkt moving up, you can easily generate additional income on rolling up the Puts while managing the call side. But put writing may not be allowed in IRA type accounts (can do very wide put spreads, but sub optimal)
----Best income strategy would be to accept letting go of shares after a couple of forward (up and out ) Rolls.. you can just buy the stock again and start option selling again... covered strangles work phenomenally well if user is okay with assignment..

I can go on and on, but this is brief description of how I do it.... One thing to note is this is NOT passive income strategy where you set it and just collect income. this needs monitoring, understanding of intermediate level option principles and needs user to make decisions without hesitation..

[specialkayme]

Yeah, a better back test is needed than an, ahem, 2018-2020 one (you should see my 3 week long r/WSB FOMO back test :-).

For sure. But the issuance of MWF expiring options is somewhat new, so it's almost impossible to create a reliable backtest going back 10+ years, at least on a 2dte strategy.

But, a 2007-2019 backtest by spintwig showed a few 7dte and 45dte short put strategies outperformed buy and hold, not just on an overall return basis, but on a risk adjusted return basis as well. Not all strategies, on all indexes, of course. Perhaps anomalies, perhaps spintwig stumbled upon a good formula while PUT and WPUT didn't, perhaps a classic example of torturing the data until it tells you what you want to hear. I don't know. I do know the data puts a fine line between destruction and profit, depending on who runs the tests. But I don't think the point is to say "this will always beat b&h" or "this will never beat b&h." The point is to say "this may be a viable strategy" which may outpace the market in some years, may not in other years, or may provide less drawdowns.

I do know it's working well for me, and significantly outpacing market returns. The key is not to let it continuously ride, as an inevitable drawdown on the strategy will come, and if you have all your chips on the table when it happens it will hurt bad. Better to get some gains, pull back and let the house money ride for a bit. At least that's me.

It'd be interesting to see the returns on a PUT strategy that converts to a B&H strategy after the first major decline.

From what I've seen, I would expect it to be lackluster at best.

WealthyOption.com had* some interesting research and backtest data, going back 10+ years on writing naked puts, much like spintwig's data but extended back. The strategy underperformed the market for something like 6+ years straight . . . until COVID. Once COVID happened, the strategy had a massive draw down event, but then started printing cash, as volatility rose and premiums on puts became incredibly juicy, but the low delta puts were very unlikely to fall ITM (due to increased volatility). It quickly outpaced the market. Why WPUT hasn't done the same, I don't know.

*I say had, because it was open source. Today it appears he pulled the website, and the data it had, into a private group thing. You may be able to ask for access if you're interested, I don't know.

[vand]

Remember that options are derivatives. They are not assets. Engaging in an options strategy is trading by any other name, and we all know what the long term statistics are on profitable vs non-profitable traders (by profitable, that means outperform buy and hold in a CC strategy).

If it was so easy to enhance returns using options strategies don't you think the hedge funds with their armies of quants would all be doing it already? Like the market in general, options are correctly priced the majority of the time which means and you will neither win nor lose over the long run.. but you will certainly suffer trading costs and taxes.

[talltexan]

For several years I've owned a covered call etf. I get the higher yield that this strategy would produce, but with very little effort.

The downside is that the underlying assets basically are $QQQ, so while I've been collecting about 1%/month in cash flow, the underlying index has gained 50%.

[ROF Expat]

OP,

My father consistently wrote covered calls on individual stocks in his portfolio during his retirement.   Years ago, when I asked him about it, he said the strategy was useful for his specific situation.  He estimated that it added a percent or so to his earnings most years but admitted the risk of missing the upside of major jumps.  He also pointed out that he had many hours of free time in retirement that he could use to manage his portfolio.  To this day, I recall him saying that, although he invested in individual stocks and wrote covered calls, he strongly advised me to just buy and hold low-cost funds.  I took his advice and have never regretted it.  I am FIREd myself, now, and still stick with an index fund buy and hold strategy. 
Dad is very much a walking example of "the millionaire next door" and he pretty much FIRE'd before anybody had heard the term.  He uses some relatively sophisticated investing tools, but he will always insist that there's no silver bullet and no real shortcut around the need for consistent and disciplined saving and investing.   

I don't know if he's still writing covered calls (I haven't asked), but I suspect he is.  He recently told me that he has begun shifting his investments toward a portfolio that will not require any active management in preparation for the day he might not have the capacity to handle it or he passes away. 

[specialkayme]

Like the market in general, options are correctly priced the majority of the time which means and you will neither win nor lose over the long run.. but you will certainly suffer trading costs and taxes.

And that is what I find so fascinating about options.

Lets assume for a moment that efficient market hypothesis is correct, in that all stocks are correctly priced and fully incorporate all available news (a position I would assume 99% of visitors to this site would agree with). Options aren't directly priced based on the value of the underlying. The price of the underlying is a component to finding the option's value. They're priced based on the projected change in the underlying over a given period of time. An option is essentially a bet that an underlying will or will not increase/decrease by a set amount over a set period of time. So an underlying could be properly priced, but an option isn't necessarily by virtue of the fact that the underlying is properly priced, as it's a projection of future events that is difficult if not impossible to price into the value of the option.

To come to that projection of future events, you need to assume the stock's volatility moving forward, or how much the stock could move over a given period of time. No one can predict the volatility of a stock moving forward. So instead they make a guess, it's Implied Volatility. Now right there should give you some level of indication on where this is going. Option prices are fixed based on guesses moving forward, and no one should be able to accurately predict the future. If the Implied Volatility is accurate (assuming all other pricing components are as well), the option is fairly priced. If the guess as to future volatility is incorrect, the option is poorly priced. Implied Volatility though relies on the psychology of the traders of the market, and fear is a controlling factor when placing trades. Fear that something bad will happen, but not so bad as to stop you from trading. Study after study has shown that Implied Volatility is over estimated and inflated compared to realized volatility. Meaning, according to current option pricing models, the options typically aren't properly valued. If you believe the studies, the options aren't always accurately priced. If you don't believe the studies, the current pricing models should show the true current value of an option, and you could very easily run a BS model on an option and find a dozen discrepancies with currently traded options every hour. If that's what you believe, you can buy the underpriced ones and sell the overpriced ones, and if the implied volatility is accurate (in that all available information is built into the option price) you should be able to make a quick and easy buck. And that's exactly what the founders of the BS model did, and the fund went belly up, because BS models do not accurately predict the value of the option. Why? Probably because implied volatility is overstated. But that's a guess.

But, for the sake of argument, lets assume that the option also follows the efficient market hypothesis, and is correctly priced today. Now, lets also assume Random Walk applies to pricing movements over time (again, something 99% of visitors of this site should agree with), in that a stock (and therefore the option) moves randomly, just like a coin toss. No one can predict what tomorrow will bring, either a heads or a tails, a gain or a loss. But progressive coin tosses will line up with an even bell curve distribution over time, giving you a good idea of probabilities. That's exactly how options are priced. They assume a random walk (with drift equal to its implied volatility), and place the distribution of probable events on a bell curve and price it based on standard deviation projected moves. If the stock, and therefore the option, moved randomly (at least indexes) according to its implied volatility, their price movements would fall on the bell curve and they would be accurately priced. And if you believe in efficient market hypothesis and random walk, options are literally perfect for you. It will literally give you a statistical probability that you'll make or lose money.

But the actual daily movements of indexes don't fall on a bell curve. The graph of the daily movements show a bell curve that suffers from skew and kurtosis. There are SIGNIFICANTLY more 1 standard deviation daily moves, and significantly more 5+ standard deviation moves, with significantly less moves in between. Natenburg's Option Volatility & Pricing has a fantastic chart on this, if you're interested, showing more days with small moves than the standard deviation predicts, less days with intermediate moves, and more days with big moves, in both directions. Taleb also shows similar results. From 1916-2003, if the DJA followed a bell curve of daily moves, you would see 58 days where the index moved 3.4% or more, when in reality you saw 1,001 occurrences. It would take 300,000 years (1 in 50 billion odds) of watching the stock market to find a day with a move of 7% or more, something no one reading this should have ever experienced once, let alone more than once, when in reality we had 48 of those occurrences in the past 100 years (4 in the last year).

So the bell curve doesn't fit option pricing. And yet, it is still used to price options. If it's wrong, why is it used to place a value on options? I don't know the answer, but I believe its because current pricing models and current statistics fit "close enough" and no one can figure out a more accurate pricing structure.

Now what does all of this really mean? The indexes do not follow a purely random walk, as it's movements are both more probable (more 1 standard deviation moves than statistics say should occur) and less probable (more 5+ standard deviation moves) than statistics would allow. And yet, the movement is not predictable. So it's random, but not random. What in the world?

I'm not smart enough to figure that out. But I am smart enough to realize that, on a daily basis, small moves in the index are under estimated, intermediate moves in the index are overestimated, and large moves in the index are under estimated. And skew exists. So buying ATM or near the money calls, selling 30-5 delta calls/puts, and buying far OTM options, over the long haul, could be worthwhile, as they aren't accurately priced based on information provided. Now whether they really are a series of viable strategies is up to you, and your stomach for volatility and potential draw downs.

[ChpBstrd]

^ A few questions on some assumptions above:

1) If IV is higher than future realized volatility most of the time, isn't that the same thing as saying IV accounts for fat-tail events?
2) If IV is higher than future realized volatility most of the time, wouldn't somebody come along and make a fortune selling strangles, or would that only last until a fat tail event wiped them out?
3) Does IV really rely "on the psychology of the traders" or could somebody come along and write a computer program that would defeat their emotionality and win using statistics?
4) If actual stock returns did not resemble a bell curve, and instead resembled a head-and-shoulders pattern, would that be difficult to write into the software that trades options on behalf of high-frequency traders? Could the software just use actual past returns as its source data to estimate IV at each strike price?

[specialkayme]

1) If IV is higher than future realized volatility most of the time, isn't that the same thing as saying IV accounts for fat-tail events?

Not exactly. If IV accounted for fat-tail events, you would see a wider distribution of higher standard deviation moves. But you don't. You actually see less 2-4 standard deviation moves, followed by more 5+ standard deviation moves.

Higher IV would flatten out the bell curve. Actual results show a bell curve pulled tighter, and the tails pushed up. So it's actually less volatility for most moves, followed by more volatility for a small number of moves.

2) If IV is higher than future realized volatility most of the time, wouldn't somebody come along and make a fortune selling strangles, or would that only last until a fat tail event wiped them out?

That's the argument. Yes, IV is inflated. Yes, the 30 delta options are selling cheaper than they should. But the one large loss will wipe out any money you made. Conceptually it makes sense. But the evidence isn't showing it. Backtests show a number of 30, 10, 5 delta strategies that should* survive for a century. They experience the massive draw downs, and survive, even turning a profit. But then again, it matters on whether you believe the options are pricing in something more than a 1 in 50 billion event, and we haven't seen it yet. Also, that we will see it. I don't know the answer to it, but I find it fascinating.

*Keep in mind, you couldn't trade options longer than 50 years ago, and you couldn't trade indexes longer than 40 years ago, let alone options on indexes. So everyone is kind of guessing on some of the historical data that goes back further than 10 years. And, intraday data is expensive, so few are running the tests, and I haven't seen anyone that has anything older than 15 years worth of intraday data, even if they are willing to cough up the high price tag for it.

3) Does IV really rely "on the psychology of the traders" or could somebody come along and write a computer program that would defeat their emotionality and win using statistics?

To be clear, that's my interpretation of why IV is inflated. I haven't heard anyone else express that (although maybe it's out there). But yes, a computer program could defeat the emotionality in option pricing, assuming that all of the inconsistencies is based on emotionality. But there's more to it than that. As the bell curve doesn't reflect actual option pricing, and a pricing model has to rely on a bell curve, even if you wrote a new program it shouldn't be able to put a new pricing model in place. And if you did, you just won yourself a nobel prize (literally).

4) If actual stock returns did not resemble a bell curve, and instead resembled a head-and-shoulders pattern, would that be difficult to write into the software that trades options on behalf of high-frequency traders? Could the software just use actual past returns as its source data to estimate IV at each strike price?

I don't think I'm the right person to answer that (I have no clue).

[vand]

Like the market in general, options are correctly priced the majority of the time which means and you will neither win nor lose over the long run.. but you will certainly suffer trading costs and taxes.

And that is what I find so fascinating about options.

Lets assume for a moment that efficient market hypothesis is correct, in that all stocks are correctly priced and fully incorporate all available news (a position I would assume 99% of visitors to this site would agree with). Options aren't directly priced based on the value of the underlying. The price of the underlying is a component to finding the option's value. They're priced based on the projected change in the underlying over a given period of time. An option is essentially a bet that an underlying will or will not increase/decrease by a set amount over a set period of time. So an underlying could be properly priced, but an option isn't necessarily by virtue of the fact that the underlying is properly priced, as it's a projection of future events that is difficult if not impossible to price into the value of the option.

To come to that projection of future events, you need to assume the stock's volatility moving forward, or how much the stock could move over a given period of time. No one can predict the volatility of a stock moving forward. So instead they make a guess, it's Implied Volatility. Now right there should give you some level of indication on where this is going. Option prices are fixed based on guesses moving forward, and no one should be able to accurately predict the future. If the Implied Volatility is accurate (assuming all other pricing components are as well), the option is fairly priced. If the guess as to future volatility is incorrect, the option is poorly priced. Implied Volatility though relies on the psychology of the traders of the market, and fear is a controlling factor when placing trades. Fear that something bad will happen, but not so bad as to stop you from trading. Study after study has shown that Implied Volatility is over estimated and inflated compared to realized volatility. Meaning, according to current option pricing models, the options typically aren't properly valued. If you believe the studies, the options aren't always accurately priced. If you don't believe the studies, the current pricing models should show the true current value of an option, and you could very easily run a BS model on an option and find a dozen discrepancies with currently traded options every hour. If that's what you believe, you can buy the underpriced ones and sell the overpriced ones, and if the implied volatility is accurate (in that all available information is built into the option price) you should be able to make a quick and easy buck. And that's exactly what the founders of the BS model did, and the fund went belly up, because BS models do not accurately predict the value of the option. Why? Probably because implied volatility is overstated. But that's a guess.

But, for the sake of argument, lets assume that the option also follows the efficient market hypothesis, and is correctly priced today. Now, lets also assume Random Walk applies to pricing movements over time (again, something 99% of visitors of this site should agree with), in that a stock (and therefore the option) moves randomly, just like a coin toss. No one can predict what tomorrow will bring, either a heads or a tails, a gain or a loss. But progressive coin tosses will line up with an even bell curve distribution over time, giving you a good idea of probabilities. That's exactly how options are priced. They assume a random walk (with drift equal to its implied volatility), and place the distribution of probable events on a bell curve and price it based on standard deviation projected moves. If the stock, and therefore the option, moved randomly (at least indexes) according to its implied volatility, their price movements would fall on the bell curve and they would be accurately priced. And if you believe in efficient market hypothesis and random walk, options are literally perfect for you. It will literally give you a statistical probability that you'll make or lose money.

But the actual daily movements of indexes don't fall on a bell curve. The graph of the daily movements show a bell curve that suffers from skew and kurtosis. There are SIGNIFICANTLY more 1 standard deviation daily moves, and significantly more 5+ standard deviation moves, with significantly less moves in between. Natenburg's Option Volatility & Pricing has a fantastic chart on this, if you're interested, showing more days with small moves than the standard deviation predicts, less days with intermediate moves, and more days with big moves, in both directions. Taleb also shows similar results. From 1916-2003, if the DJA followed a bell curve of daily moves, you would see 58 days where the index moved 3.4% or more, when in reality you saw 1,001 occurrences. It would take 300,000 years (1 in 50 billion odds) of watching the stock market to find a day with a move of 7% or more, something no one reading this should have ever experienced once, let alone more than once, when in reality we had 48 of those occurrences in the past 100 years (4 in the last year).

So the bell curve doesn't fit option pricing. And yet, it is still used to price options. If it's wrong, why is it used to place a value on options? I don't know the answer, but I believe its because current pricing models and current statistics fit "close enough" and no one can figure out a more accurate pricing structure.

Now what does all of this really mean? The indexes do not follow a purely random walk, as it's movements are both more probable (more 1 standard deviation moves than statistics say should occur) and less probable (more 5+ standard deviation moves) than statistics would allow. And yet, the movement is not predictable. So it's random, but not random. What in the world?

I'm not smart enough to figure that out. But I am smart enough to realize that, on a daily basis, small moves in the index are under estimated, intermediate moves in the index are overestimated, and large moves in the index are under estimated. And skew exists. So buying ATM or near the money calls, selling 30-5 delta calls/puts, and buying far OTM options, over the long haul, could be worthwhile, as they aren't accurately priced based on information provided. Now whether they really are a series of viable strategies is up to you, and your stomach for volatility and potential draw downs.

Ok.. hurt my head jusy reading all that.  In general I agree with the gist.. that the market is not perfectly efficient and that in reality fat-tails exist which can be exploited by very savvy investors.

Taleb is a proponent of exploiting such imperfections.

However.. all this is getting away from the original premise of generating a steady regular bit of extra income by writing options. This is the domain of black swan type funds where you earn -99% for 99 months in a row and then make a 200-bagger in the 100th month. You may be able to beat the market in the long term, but it isn't useful if you have no idea of the predictability of those returns.

Taleb's fund may beat the market by a handy amount over the long run, but that doesn't make it a good vehicle for dumping you whole portfolio in.

[MustacheAndaHalf]

The OP, digam, mentioned using just 1-2% to learn how stocks work.  That seems like too little to generate income, while an all options portfolio seems like too much.

specialkayme - Do you have a link to that data on the frequency of small, intermediate and large gains?  The data you present suggests there's a dead zone in the area of intermediate returns.  I would guess you could sell covered calls near the start of that area, and buy protective calls near the upper edge of that area.

The most common case is a gain, from selling an option that expires.  With an intermediate or big gain, the call you bought provides a limit to the damage.  There's a loss, but it's limited to the distance between the call you sold and the one you bought.

If selling covered calls is the safest way to start with options, then I assume a covered call with added protection is even safer?

[dignam]

^Yes, I'm definitely still in the accumulation stage, so I'm stuffing all my pennies into index funds, save the small amount I'm using to learn about options.

From what I understand and have seen so far, the Wheel strategy will never give you a major windfall, so it will never be like "the 100th month" as vand stated it.  In return for getting a little more consistent income, you are sacrificing some potential big gains and taking on the risk of being assigned the stock (since you are starting with selling a cash covered put).  But, as long as you aren't selling puts at like the 60 delta or something crazy, the contracts will usually expire, which is the goal.

[talltexan]

I've tried to play around with options, but generally not kept up with index BnH.

Here's how I'd approach the problem: BnH safe withdrawal rate is 4%. How can you use an options strategy to create double that? If there's truly a case that options reduce risk, is accepting a lower average return (SP500 returned 10% historically) for dramatically less risk possible?

[specialkayme]

However.. all this is getting away from the original premise of generating a steady regular bit of extra income by writing options. This is the domain of black swan type funds where you earn -99% for 99 months in a row and then make a 200-bagger in the 100th month. You may be able to beat the market in the long term, but it isn't useful if you have no idea of the predictability of those returns.

Taleb's fund may beat the market by a handy amount over the long run, but that doesn't make it a good vehicle for dumping you whole portfolio in.

I think you missed the most crucial implication of Taleb's work though. Taleb narrowed down on one portion of the probability curve, the fat tails. Taleb focused on fat tail events, and showed they're priced incorrectly. But their price is largely based on the probability placed on the odds it will or will not occur. The standard bell curve assumes the odds of a 7%+/- move is approximately 1 in 76 million (or approximately a 0.0000013% chance). So if the market is efficient, you should be net even (before taxes and commissions) over 76 million trades if you bet a 7% move will occur. And so the market assumes if you put $1 down every day on the bet that the move occurs, and you repeat the bet for 300,000 years, it'll cost you $76M, and you'll win once every 300,000 years, and it'll pay out $76M, for a (roughly) net wash over those 300,000 years, for a net wash of $0 gains. But history of the markets from 1916-2003 show the odds are closer to approximately 1 in 460 (or a 0.2% chance). Which means if I placed that same $1 bet every day for 300,000 years, it would cost me $76M, but I'd walk away with $13Trillion (or ~$13,432,000,000,000). That's the work (in a paragraph) that Taleb focused on.

But the sum under the bell curve is constant. The total probability under the curve must equal 100%. If you rob 0.2% and give it to the tails, it has to come from somewhere else in the bell curve. If the bell curve is assuming there is a 0.0000013% chance the market will move 7%+/-, it's also assuming there is a 99.99987% chance it will NOT move 7%+/-. But if the odds are actually 0.2%, then there is actually a 99.8% chance it will not move. That 0.2% chance had to move from somewhere in the center. Which means the market is not only under valuing the 5 standard deviation moves, but that it must be overvaluing everything between 5 standard deviation moves to some extent or another, as the market believes they will occur more frequently than it actually does.

Now how that 0.2% chance is spread out is important. It could be evenly distributed among all occurrences between 5 standard deviation moves. If that's the case, there's little opportunity to profit (as your odds for any one particular trade may have moved from 32% to 32.0000000001%, and good luck turning a profit on those increased odds after taxes and commissions). Or, maybe the market has pushed that increased probability into a narrow range of probabilities (the 2-3 standard deviation moves, for example). Or, maybe the market has more inconsistencies in its probability estimate than just the fat tails (meaning its not only underestimating the 5+ standard deviation moves, but maybe its also underestimating, say, the 1 standard deviation moves). Or maybe both. Those questions really matter. Because if the market is undervaluing the fat tails, and undervaluing the 1 standard deviation moves, there is a large amount of probabilities that have to be pushed somewhere else, and the overvaluing isn't going to the 1 standard deviation moves or the 5 standard deviation moves.

[specialkayme]

specialkayme - Do you have a link to that data on the frequency of small, intermediate and large gains?  The data you present suggests there's a dead zone in the area of intermediate returns.  I would guess you could sell covered calls near the start of that area, and buy protective calls near the upper edge of that area.

Natenburg's Option Volatility & Pricing, Figure 23-8 of the most recent edition. I think you're better off reading it in the book, as I have no idea if this is an accurate link, but you can see what I believe is an accurate picture of the figure here http://1.droppdf.com/files/23rd5/option-volatility-and-pricing-advanced-tr-sheldon-natenberg.pdf on Page 3395. I'd feel more comfortable with reading it from the book, either off amazon or your local library if you're so inclined (it might take a few renewals to read through it though).

The information isn't new to Natenburg, although he's just one that put it all in one graph. His graph shows an S&P500 from 2003-2012 has a kurtosis of 10.41 (when a standard deviation curve is 3). Mandelbrot (a mathematician, not a trader) has the s&p500's 1970-2001 kurtosis of 43.36 (or 7.17 without the '87 crash data). Same story, different data set, different person crunching the numbers.

OptionAlpha's work consistently shows 5-30 delta options are poorly priced, as implied volatility is overstated. Which lines up with Natenburg and Mandelbrot's work. Spintwig's data set shows very similar occurrences. WealthyOption's data set showed similarities. Some find the sweet spot at 6 delta, others find it at 10 delta. Crunch the numbers on one decade and it shows a sweet spot at 20 delta, and another decade shows a sweet spot at 15 delta. Which makes sense when you think about it, as events like the '87 crash can move the kurtosis 6x larger. Which data set is more accurate, I don't know. Only the next 100 years of data will tell you that. But to me it's consistently showing that options aren't properly priced, in that 1 standard deviation moves are undervalued, 2-4 standard deviation moves are overvalued, and 5+ standard deviation moves are undervalued.

Now, whether you can turn that into a consistent income stream depends on 1) how long you can play the game [and with it, your stomach for draw down events], 2) how much capital you can allocate, and 3) how far off they are valued.

If selling covered calls is the safest way to start with options, then I assume a covered call with added protection is even safer?

For one, I would not say covered calls is the safest way to start with options. Just the strategy that's most easily understood, without huge downside loss (if you feel comfortable owning the underlying, as most B&H investors are anyway). Call buying is probably the safest as each individual trade has small risk allocated to the trade. But the probability of profit in call buying isn't great. Put selling has a high probability of profit, even if the profit is limited, which over successive trades could create positive expectancy. And put selling has the same profit graph as covered calls, but requires a fraction of the collateral. But put selling has large downside potential (actually equal to owning the underlying itself, so not massive compared to B&H investors), which scares most first time options traders. The idea of owning the underlying in the event it declines in value acts as a security blanket to some, which is why they prefer covered call writing.

But yes, covered call with added protection (I'm assuming you mean buying a protective put) is safer in that you won't experience a large draw down event. But the cost of the put will significantly cut into your profit margin, which decreases your probability of profit. Depending on the pricing, it may reduce (but maintain) your positive expectancy, or it might eliminate it entirely. Depends on the trade (and the pricing).

[specialkayme]

The OP, digam, mentioned using just 1-2% to learn how stocks work.  That seems like too little to generate income, while an all options portfolio seems like too much.

Yes, an all options portfolio is too much. At least to me.

But, an all options portfolio actually doesn't need to be all options. If you sell options, you have margin requirements, meaning you have to have a certain amount of collateral. That collateral can be cash, stocks, bonds, whatever. It just has to hold value according to the broker. Which depends in part on the volatility and risk of what it is. Say you have $100k in an account. You can keep all of that $100k in cash, and write options against it, or part of it. Or, you can buy bonds with it. It will reduce the buying power you have though. Say it reduces it by 50%. That means you have $100k in bonds, and you can write $50k in options.

Now here's where it gets a little crazy (too crazy for me, but interesting still). Say you had $100k in an account. You buy $100k in bonds. You now have $50k to play with in options, while still having the security of the bonds. You can then use that $50k to buy synthetic stock in the SPY using options. You buy a call and sell a put at the same strike. Your profitability is equal to owning the stock. If it goes up in price, you make money, if it goes down in price, you lose money. No difference when compared to owning the stock. Except, 100 shares of SPY cost ~$39,000, and one synthetic stock (worth 100 shares of SPY) has a margin requirement of ~$9,000. So you could either:
A) Use your $100k to buy 255 shares of SPY, or
B) Use your $100k to buy $100k of bonds, then write 5 synthetic stock positions (requiring ~$45,000 in collateral) and have the profit/loss of roughly 500 shares of SPY (while still having the portfolio diversification of $100k in bonds).

Of course, if SPY goes up, you win. If SPY goes down, you lose bigger than if you held the shares directly (that's how leverage works). If SPY goes down and bonds lose value, ouch indeed. Hence why I'm not comfortable with it. But an interesting strategy.

[ChpBstrd]

If there is a gap between historically expected probabilities and the probabilities implied by options prices at various points along the bell curve, I wonder if it might be because the prices are actually set based on the expected compound returns of the strategy instead of just simple returns. After all, the market makers have to play every options strategy simultaneously and infinitely in the future in a way that makes the most money.

A strategy that wins 70% of the time compounds its money faster than a strategy that wins 1% of the time, or every 20 years. Therefore, a program playing the 70% winning strategy can accept a much lower house edge than the strategy that wins 1% of the time. This is similar to how a retailer can accept lower margins on fast-moving items, but has to put a higher margin on slow-moving items.

What if, at various parts of the bell curve the optimum house edge for compounding has a shape that is not the inverse of the bell curve itself? The optimum compounding curve would be a factor of both the compounding function and the historical odds.

[specialkayme]

If there is a gap between historically expected probabilities and the probabilities implied by options prices at various points along the bell curve, I wonder if it might be because the prices are actually set based on the expected compound returns of the strategy instead of just simple returns. After all, the market makers have to play every options strategy simultaneously and infinitely in the future in a way that makes the most money.

If so, you'd see a difference between pricing of LEAPs contracts (that have two year carrying costs for those that write them) vs very short term expiring options, say 1 day (that have very small carrying costs for those that write them, and compound quicker). I've seen no difference between pricing that can't be explained by one of the greeks (for example, short term expiring options suffer from significant theta decay when compared to LEAPs, which is still a factor of most option pricing models). But, I don't examine the price of every option over time.

The optimum compounding curve would be a factor of both the compounding function and the historical odds.

That's the crux of the dilemma. The market experiences random walk. It is random. Random events fall on a normal distribution. The market does not fall on a normal distribution. Which means the market is not random. And yet, it does not transpire according to any recognizable method. Which is the definition of random.

If you have to include historical odds, the movements aren't random. And yet, they are . . . .

Mandelbrot's The (Mis)Behavior of Markets is a very interesting read on this topic, where he uses fractals to recreate the market, and shows fairly compelling evidence against efficient market hypothesis, Black-Scholes, and random walk (at least based on what he presents). Interesting discussions on how markets don't follow a normal distribution, how the market has a "memory", among other concepts. But I wish he was able to discuss why they don't follow a normal distribution, or what distribution they follow, instead of investing coefficients to describe how much an underlying isn't following a normal distribution.

[yoda34]

Man oh man - how did I miss this conversation? My apologies for joining late and if I rehash something someone already said my apologies.

I've been selling options for additional (on top of buy and hold / and specific equity valuation portfolio) for a couple of years now. I've also been using options to hedge my long portfolio very successfully for a couple of years now (and took several ideas from some of the posters in this thread!) I've done everything from covered calls, spreads, collars, etc. So a couple of points from me:

-IV isn't a traders feeling, it's a component of option pricing. I.e. when the market maker sets the price of the option the MM estimates volatility as part of the price. Just as the price of an individual equity or index is set by the market, the overall IV of any one option is set by the market. As we all know the market is very efficient and so IV is also very efficiently set

-If IV is efficiently set, why is IV almost always > than realized volatility?  IV is a measure of certainty/risk - meaning the more things are uncertain the higher the IV will go - you can see this directly in the VIX which is measured against the IV of the S&P 500. A low VIX doesn't mean that stocks will go up, it just means that the market thinks most of the things impacting price are known and priced into the underlying. The price of an option is set by the market maker writing the option not by the buyer. Consider that supply and demand for an option do NOT move the option price (at least not directly). The option price is set by IV and Time and IV is based on the underlying. However as we all know IV isn't perfect (for example COVID comes along and the market tanks) - therefore the option market makers set IV to be greater than realized as the risk premium for writing the option. If IV was = to Realized or < realized consistently no one would write an option. This is why the expected value of buying an option is almost always negative. The expected value of writing options is equal to the IV / Realized premium which roughly correlates to the expected return of the underlying (SPX options premium on puts is ~6/7% and you can see this in earlyretirementnow's option returns where he is using short puts to express a long position) 

-The market is not a bell curve. Mendelbrot (already mentioned here) has made a great argument that the market is actually a series of normal distributions that move between distributions as a function of a power law. It's interesting to note that Fama agrees with Mendelbrot on this point. What that means is that MOST of the time the market prices fall randomly inside the expected bell curve, and every now and then (randomly) jump to a different distribution in a way that resembles a power law (in such cases massive standard deviation jumps can occur). This power law dislocation is why option writes have to have an IV premium to cover their risk of writing the option.

Anyway - that's all mumbo jumbo. To the OP's question, I now sell ES Mini Future spreads and option spreads while also having my portfolio long the S&P 500. I've consistently been able to hedge my long portfolio and add 7% in option returns on top of that. It took me a very long time to get here and i lost alot of money along the way but am now fairly comfortable with the risk and my ability to execute.

[specialkayme]

-IV isn't a traders feeling, it's a component of option pricing. I.e. when the market maker sets the price of the option the MM estimates volatility as part of the price. Just as the price of an individual equity or index is set by the market, the overall IV of any one option is set by the market. As we all know the market is very efficient and so IV is also very efficiently set

When the MM sets the price of the option, the MM estimates volatility as part of the price. The MM is a trader (or at least, the person entering the trade for the MM, or probably more accurately the person programing the code for the algorithm that enters the trade for the MM is a person). The trader had a feeling about volatility. So . . . how is IV not an impression of the trader's projection of future volatility?

But that assumes 100% of all option trades are priced based on MM . . . but they aren't. A MM sets a bid and an ask that they are willing to trade at, based on their own calculation of (in part) implied volatility. You can go in and trade the bid or the ask if you'd like. Or you can select a mid price, and place your order. That trade becomes the new bid or ask. So now you've calculated the new IV (among other things) and priced it into the option you're willing to trade at. If the trade is filled, it's no longer filled at the IV calculated by the MM. It's at the IV calculated by you. So the trade is executed based on the IV set by you (and the other person on the other side of the trade). That doesn't have to be filled by a MM. It can equally be filled by another trader. A trader that equally calculated an IV that's different from the one calculated by the MM.

But it doesn't have to actually be calculated. I can look at an option and decide to buy it at $8, when the current bid ask spread is $7 and $10. Did I calculate a new IV? Not directly. I got a feeling on where the stock will go over a period of time. According to most model pricing theories, we all know the time, price, strike, and risk free rate of interest, so by placing a trade at $8 I've effectively set a new IV on that trade. All of that is based on my subjective belief that I'll make money on the trade. Or, a feeling.

Alternatively, if the MM sets the bid ask spread based on their calculation of IV, lets say all the asks get gobbled up, as fast as the MM will put the trade out there. Do you think they'll keep the ask in the same spot? Not likely. They'll move it further away from the spread. All other things remaining equal, they didn't move it because they suddenly calculated a new IV, they did it because they can make more money by offering a different IV than they were originally willing to trade at. And the traders on the other side were willing to make the trade because they internally calculated a different IV (or another factor) and believed the MM's calculation of IV was incorrect. But as no other BS component changed, the reflected IV changes as a result once the new trade is placed.

So yes, MM sets a baseline range for IV, but the market overall controls the IV expressed in the option. Individuals who are willing to buy and sell at a set price control the metrics of the option trade, and as price, underlying price, strike, time, and risk free interest rate are all easily calculated, the remaining variable to solve for is IV.

-The market is not a bell curve.

Exactly. But BS modeling assumes it is. Hence the potential for price discrepancy. BS modeling was introduced long before the power law discussion was applied to option pricing. And the BS model doesn't account for the power law function. And yet, the BS model (along with others) is still widely in use today.

[yoda34]

Yep - there is a lot of over simplifying here - but I only addressed the MMs because by almost by definition everyone else buys and sells at a worse IV than the MMs unless you manage to cross the spread. MMs (for the most part) buy at the bid and sell at the ask. If you sell inside the spread you are selling at a lower (and worse)  IV than the MMs.

IV is a much as a "feeling" as the individual price of any listed security. I guess you could call that a feeling, i call it price discovery. When I look at the price of MSFT, or SPX I don't think of that as a feeling but as a consensus price based on active trading and discovery. This is literally the point you made about MMs moving the IV when there is lots of action. This is maybe just semantics so probably not important.

I don't know of any option MM that use pure BS to price options. They've all  modified to account for standard deviation shits that fall outside the normal Gaussian probabilities. The lasting volatility smile and put skew from 87 is an example.

[specialkayme]

I don't know of any option MM that use pure BS to price options. They've all  modified to account for standard deviation shits that fall outside the normal Gaussian probabilities.

Any information you can share on what is being used?

Almost no one (other than new retail traders) are using a pure BS model to price options, but I haven't heard of any pricing model that accounts for realized distributions. Mandelbrot's theories aren't widely accepted in the finance community (in part because they run counter to efficient market theory, random walk, and technical analysis), and I hadn't heard of anyone that was able to utilize his Hurst coefficient (and was it Alpha coefficient) in a workable pricing model.

[MustacheAndaHalf]

specialkayme - Do you have a link to that data on the frequency of small, intermediate and large gains?

Natenburg's Option Volatility & Pricing, Figure 23-8 of the most recent edition. I think you're better off reading it in the book,

S&P500 from 2003-2012 has a kurtosis of 10.41 (when a standard deviation curve is 3). Mandelbrot (a mathematician, not a trader) has the s&p500's 1970-2001 kurtosis of 43.36 (or 7.17 without the '87 crash data).

The latest kindle edition costs $51, but an earlier edition costs $38.  I wonder how many libraries will purchase the $120 hardcover edition?  Hopefully I remember to look for it.  I wound up buying another book ("Understanding Options 2E", Michael Sincere) which is cheaper and probably closer to my ability level.

Crunch the numbers on one decade and it shows a sweet spot at 20 delta, and another decade shows a sweet spot at 15 delta. ... 1 standard deviation moves are undervalued, 2-4 standard deviation moves are overvalued, and 5+ standard deviation moves are undervalued.

My first research into delta didn't clear it up for me.  For SPY calls expiring 2021 Dec 31, where is the 20 delta call?

If selling covered calls is the safest way to start with options, then I assume a covered call with added protection is even safer?

For one, I would not say covered calls is the safest way to start with options. Just the strategy that's most easily understood, without huge downside loss (if you feel comfortable owning the underlying, as most B&H investors are anyway). Call buying is probably the safest as each individual trade has small risk allocated to the trade.

To clarify, I'm thinking of someone new to options.  Someone new to options can sell covered calls and lose some potential gains, maybe be forced to buy back into the market at a higher price.  But they won't destroy their portfolio.

Especially combined with greed, someone new to options could put everything in call options, which then expire worthless.  Their portfolio is gone.  That's why I'd estimate covered calls to be safer or lower risk - but I mean for someone new to options.

[CloudLiu]

I've F.I.R.E since Nov, 2019. I've been selling cash secured puts on individual stocks since the March, 2020. In little more than 1 month, I've made almost the same amount in 2021 (Jan to Feb 12) as the total I made in 2020(Mar to Dec). The income from first few months were little volatile. It seems I learned to stabalize the option income since the last four months.

It's an income strategy. It's not a strategy to maximize return.  Many times, I found the underlying stock performed slightly better than the put premium ROI. Also, my growth stocks portion performed slightly better than put selling. It's an exchange of uncertain future capital gain for certain current income. When the stock rise, they rise substantially more than the option premium ROI. (Premium/assignment cost)

It's useful to have consistent income when we don't have a pay check. e.g. when applying for credit such as mortgage.

If you are 10 years a way from F.I.R.E, it's not useful for you. However, it helps to practice a little bit.
With option income, I don't need to worry about withdrawal rate.   I find the tiny 3% dividend  yield is useless.  5% / month option yield is at least 60% per year.

There are lots of tricks to capture more premium by selling simple cash secured puts by buyback and reselling at the right time.. You will figure out if you spend some time on it.   It took me less than 1 year to get it.

I also put 2% capital buying calls. This way is more risk more reward. It has 3 to 6 times leverage. If a stock goes up 50%, the option goes up 150%.. But if there's a black swan event and stock price stays below strike at expiration, the option is worthless, complete wipeout. So, if buying calls, take profit, keep amount invested relative fixed. Don't reinvest all profits. 

See attached for my put option income history.
 

[specialkayme]

Crunch the numbers on one decade and it shows a sweet spot at 20 delta, and another decade shows a sweet spot at 15 delta. ... 1 standard deviation moves are undervalued, 2-4 standard deviation moves are overvalued, and 5+ standard deviation moves are undervalued.

My first research into delta didn't clear it up for me.  For SPY calls expiring 2021 Dec 31, where is the 20 delta call?

Well, to answer your question directly, as I'm writing this the SPY Dec 2021 20 Delta Call is the 450 strike.

But I don't know why you would look out that far. And you wouldn't be buying the option anyway. The deltas I was referring to were to selling the short puts, typically 45 dte and under. I prefer under 7 dte. Much like flavors of ice cream, not all strategies suit all investors though.

If selling covered calls is the safest way to start with options, then I assume a covered call with added protection is even safer?

For one, I would not say covered calls is the safest way to start with options. Just the strategy that's most easily understood, without huge downside loss (if you feel comfortable owning the underlying, as most B&H investors are anyway). Call buying is probably the safest as each individual trade has small risk allocated to the trade.

To clarify, I'm thinking of someone new to options.  Someone new to options can sell covered calls and lose some potential gains, maybe be forced to buy back into the market at a higher price.  But they won't destroy their portfolio.

If you mean "Safe" as in the strategy has training wheels, then yes, a covered call strategy is a great opportunity to learn how to trade options. If you mean "safe" as in the strategy has a lower possibility of loss, then no. See above.

Safe can mean many things. If you're trying not necessarily to lose money, but not to go Armageddon on your account, I would absolutely agree with you that covered calls is a safer strategy (especially if the underlying stock is a stable blue chip or aristocrat dividend stock). If you're more concerned with not losing money, covered calls may or may not satisfy that need, but there are certainly less risky options.

Especially combined with greed, someone new to options could put everything in call options, which then expire worthless.  Their portfolio is gone.  That's why I'd estimate covered calls to be safer or lower risk - but I mean for someone new to options.

New people to options typically focus on buying calls. Because it's something they can easily understand when compared to buying shares of stock. I spend money, if the stock goes up I make money. Simple. But they continue to apply other mentalities that apply to stocks to their new options strategy. They think longer duration is the way to go, as you're buying and holding. Wrong. Options have expiration dates. You're trading the option. You will inevitably sell it. So the point is to get the best risk/reward ratio on the option. And that typically isn't long dated options (not always, depends on your strategy). They will also look at an In The Money call option (that say costs $12), an At The Money call option (that say costs $8), and an Out of The Money call option (that say costs $6), and will chose the cheaper option. Wrong. Yes, it's cheaper, but because it has such a smaller probability of profiting. All other things being equal, I'd much rather own one ITM call option than two OTM call options.

The hardest part of options for new people to understand is that they decay in value over time. For that reason, most recommend SELLING options before you BUY options, this way if you sell an option and it decays, you make money. So if you buy an option and you don't know what you're doing, and the stock stays in place, you lose money. But if you sell an option and you don't know what you're doing, and the stock stays in place, you gain money. But selling naked options comes with risk. That's why you often hear about covered call strategies. By selling the call you learn how options move, but by owning the stock you don't get "surprised" by how much you lose. It doesn't mean you lose any more or any less than not owning the underlying stock. By selling a shorter term option, it decays faster, and you aren't stuck in a trade for a long time.

But where the strategy often loses people is the collateral (stock) required for it to work. Say I want to do a covered call on AT&T (T). You buy 100 shares ($2,877) and sell a 1 week 35 delta call ($15) at the 29 strike. If the stock moves up past 29, you made $38 ($15 on the option and $23 on the stock). If it stays in place, you made $15. If it drops more than $0.15 per share, you lose money. So your max profit for the week is 1.3%. Not bad for a week's worth of work. But you had to tie up $2,900 in collateral. Instead, you can sell the 34 delta put for $14. If the stock goes up, great. You keep the $14. If the stock drops below $28.5, you lose money. But you would have lost money if it went below $28.5 anyway (under the covered call scenario). So there really isn't any difference in your profit graph. Except I only needed to tie up $500 in collateral for my naked put. So my max profit is 2.8% for the week, with the same profitability graph. Now, if you have $3,000 in your account, you can either (1) do one covered call play, hoping to make 1.3%, (2) do one short put play, using $500 in collateral and putting $2,500 in bonds or something stable (which is less risk than owning the stock), hoping to make 2.8%, or (3) you can leverage to the hills and do 6 short put plays, hoping to make $84 that week, and if it moves against you, you lose BIG. Overleverage is what killed you, not the strategy, not options.

Buying options (usually calls) is a poor strategy to learn options. You're better off selling to start. Long dated options are poor strategies to learn options on. You're better off selling short strategies. Now if you need the training wheels, buy the underlying stock as collateral and sell covered calls. If you think you can manage without the training wheels, keep the money in cash in your account and sell a short OTM put. Both will teach you options equally.

Level two is typically the Wheel Strategy, where you both sell puts and calls. But that's for another day.

[ChpBstrd]

I've F.I.R.E since Nov, 2019. I've been selling cash secured puts on individual stocks since the March, 2020. In little more than 1 month, I've made almost the same amount in 2021 (Jan to Feb 12) as the total I made in 2020(Mar to Dec). The income from first few months were little volatile. It seems I learned to stabalize the option income since the last four months.

It's an income strategy. It's not a strategy to maximize return.  Many times, I found the underlying stock performed slightly better than the put premium ROI. Also, my growth stocks portion performed slightly better than put selling. It's an exchange of uncertain future capital gain for certain current income. When the stock rise, they rise substantially more than the option premium ROI. (Premium/assignment cost)

It's useful to have consistent income when we don't have a pay check. e.g. when applying for credit such as mortgage.

If you are 10 years a way from F.I.R.E, it's not useful for you. However, it helps to practice a little bit.
With option income, I don't need to worry about withdrawal rate.   I find the tiny 3% dividend  yield is useless.  5% / month option yield is at least 60% per year.

There are lots of tricks to capture more premium by selling simple cash secured puts by buyback and reselling at the right time.. You will figure out if you spend some time on it.   It took me less than 1 year to get it.

I also put 2% capital buying calls. This way is more risk more reward. It has 3 to 6 times leverage. If a stock goes up 50%, the option goes up 150%.. But if there's a black swan event and stock price stays below strike at expiration, the option is worthless, complete wipeout. So, if buying calls, take profit, keep amount invested relative fixed. Don't reinvest all profits. 

See attached for my put option income history.

Thanks for sharing. What amount out of the money (delta) do you target? What's your ROI (cannot tell how much cash was set aside to secure those puts)?

[CloudLiu]

Thanks for sharing. What amount out of the money (delta) do you target? What's your ROI (cannot tell how much cash was set aside to secure those puts)?

Delta:

As far as I understand, Delta is not important.  if you have an idea of what the range for the price bottom is, you can sell at the money put when stock  is close to the bottom range.  If stock is far way from bottom, I will target 20% below current stock price. But stocks frequently trade at close to bottom in normal market condition so I  try to be patient and wait for good opportunities.  While I wait for good opportunities, I sell 20% below current price with 60%/ year target ROI.  Target ROI for at the money put is 100% per year.


Return:

Put selling ROI is very close to the underlying stock ROI. Picking the right underlying to sell put is important. Examples: If you sell puts in SP500 index, your ROI will around 10% per year.  if you sell put on KO, your ROI will be around 20% per year. if you sell put on BIGC, the return can be 60% to 100% per year.   If you picked a wrong stock or strike to sell put, your return can be 0% or worst negative.

I target 60% to 100% per year ROI per trade. Sometimes I got more because stock skyrocketed.   Most trades meet my ROI expectation. My  total ROI from selling puts is around 50% to 100% per year.
 

[MustacheAndaHalf]

The mention of kurtosis and Black-Scholes models inspired me to take another look at the S&P 500 options.  If options are priced accurately, they should reveal expectations about the S&P 500.

I looked at options expiring 2021 Dec 31 on SPY (S&P 500).  The $260 and $280 strikes are $2 apart, suggesting a 10% chance the market drops to $260.  If there's a 1% chance, you can use a strategy that keeps $2 and expects to lose $0.20.  If there's a 25% chance, you can pay $2 to earn $5.  An incorrect expectation could be exploited.

Using that approach, I calculated percentages for SPY options expiring Dec 31:
9% call $260(-34%)  10% put
12% call $280(-29%) 13% put
15% call $300(-24%) 16% put
19% call $320(-18%) 20% put
23% call $340(-13%) 25% put
26% call $360(-8%) 30% put

A linear relationship is weird for a bell curve with fat tails.  In portfolio visualizer's data from 1972 to 2021, the worst 5 years are -38% -27% -22% -16% -12%.  Rounding to 50 years and assigning 2% probability, I get:
-29% to -34% once (2%) vs 10% expected
-24% to -29% twice (4%) vs 13% expected
-18% to -24% 3x (6%) vs 16% expected
-13% to -18% 4x (8%) vs 20% expected

Those percentages are estimates based on history, so the 2% could be off, which has a significant impact on expected losses.  That, plus higher premiums have me favoring the last case: Selling $340 ($1776) and buying $320 ($1403) earns $373 for the 8-9% expected loss ($2000 x 9% = $180).  One failure requires 5+ successes to break even.

As a novice, I have a much higher chance to make a mistake.  My guess is deep in the money puts are lower profit, and the gain being 19% of the money at risk doesn't make it appealing.  Maybe it could work, but it's not that great.  I'll probably need to research "bull put spread" to see if I've missed something.

[MustacheAndaHalf]

The above $373/year can be improved on.
Feb -> Apr pays $109 in 2 months, repeated 6 times would give $654
Feb -> May pays $169 in 3 months, repeated 4 times would give $676
Feb -> June pays $215 in 4 months, repeated 3 times would give $645

That improves the approach to 32%-34% of the money at risk ($2000), but changes the risk profile near the option expiration.

Measuring each year's return might miss situations like 2020, where the market experienced a -35% drop but then overall returned +20% for the year.  I wish I knew how many Dec 2020 PUTs were exercised early in 2020.

[specialkayme]

As far as I understand, Delta is not important.

Delta is by far the most important metric. Multiples more important than any other greek. There are times that I won't even know the price of the underlying, and won't pay attention to the cost of the option, instead only trading based on the delta.

Put selling ROI is very close to the underlying stock ROI.

I have not found this to be correct.

If you sell puts in SP500 index, your ROI will around 10% per year. 

ROI YTD on the SPX is ~4.3%. ROI YTD on selling puts (one strategy, at least) on SPX is ~19.3%.

But your strategy may vary.

[specialkayme]

I looked at options expiring 2021 Dec 31 on SPY (S&P 500).  The $260 and $280 strikes are $2 apart, suggesting a 10% chance the market drops to $260.  If there's a 1% chance, you can use a strategy that keeps $2 and expects to lose $0.20.  If there's a 25% chance, you can pay $2 to earn $5.  An incorrect expectation could be exploited.

A much easier way to run the calculations is to look at the delta. The $260 put has a delta of -.09, and the $280 put has a delta of -.12. Which, back of the napkin math, means the market is estimating there is a 9% chance the S&P will be at $260 by year end, and a 12% chance the S&P will be at $280 by year end.

But yes, I would find your assessment quite accurate overall, and the correct way to view a potential investment.

My guess is deep in the money puts are lower profit, and the gain being 19% of the money at risk doesn't make it appealing.  Maybe it could work, but it's not that great.

Correct. ITM options generally are safer (have a higher probability of occurring), but hold lower returns. OTM options are generally much riskier (have a lower probability of profit) but hold much greater returns.

You're on the right path :)

The above $373/year can be improved on.
Feb -> Apr pays $109 in 2 months, repeated 6 times would give $654
Feb -> May pays $169 in 3 months, repeated 4 times would give $676
Feb -> June pays $215 in 4 months, repeated 3 times would give $645

That improves the approach to 32%-34% of the money at risk ($2000), but changes the risk profile near the option expiration.

Measuring each year's return might miss situations like 2020, where the market experienced a -35% drop but then overall returned +20% for the year.  I wish I knew how many Dec 2020 PUTs were exercised early in 2020.

Bingo. Shorter term options typically have much greater profitability, but you run the risk that a "black swan" event occurs.

Keep in mind markets crash down in the short term. They don't crash up. Over the long term, markets always go up, not down.

Long term options also restrict your ability to play certain probabilities. For example, the lowest delta put you can sell on SPY expiring year end is -.09. But 45 days out you could sell a -.05 put, a -.02 put, or even a 0 put. Now, the prices aren't great, but the odds are significantly in your favor.

The other thing about delta to keep in mind, if you double it that's the odds the market is estimating the underlying will be ITM at some point in the options life, but not necessarily expire there. The 45 day 373 SPY put has a delta of -.25, meaning the market is estimating a 25% chance that it will expire ITM, and a 50% chance that SPY will hit 373 at some point in the next 45 days, even if it doesn't expire there.

Now, say you sell the 373 put today, and take in $485. You could hold onto it for 45 days, assuming it expires the way you're expecting, you make $485 on ~$6k investment over 45 days. Not bad. Or, you wait 20 days. If the market doesn't move up or down, that 373 put will now have a delta of approximately -.17, and will be worth about $180. If the market goes up, it'll decay faster. Now you just raked in 62% of your expected profit over half the time. Is it worth it to take it another 25 days to take in the other 38%? You might be better off to close the trade, and repeat by selling the next 45 day put. If you can do that twice over 45 days, you'll make $610 in 45 days, rather than the original $485. Assuming you did that, the market would have to crash down to $367 in 45 days before you lost money.

I hope all of that makes sense.

[MustacheAndaHalf]

The above $373/year can be improved on.
Feb -> Apr pays $109 in 2 months, repeated 6 times would give $654
Feb -> May pays $169 in 3 months, repeated 4 times would give $676
Feb -> June pays $215 in 4 months, repeated 3 times would give $645

That improves the approach to 32%-34% of the money at risk ($2000), but changes the risk profile near the option expiration.

Measuring each year's return might miss situations like 2020, where the market experienced a -35% drop but then overall returned +20% for the year.  I wish I knew how many Dec 2020 PUTs were exercised early in 2020.

Bingo. Shorter term options typically have much greater profitability, but you run the risk that a "black swan" event occurs.

Keep in mind markets crash down in the short term. They don't crash up. Over the long term, markets always go up, not down.

Long term options also restrict your ability to play certain probabilities. For example, the lowest delta put you can sell on SPY expiring year end is -.09. But 45 days out you could sell a -.05 put, a -.02 put, or even a 0 put. Now, the prices aren't great, but the odds are significantly in your favor.

The other thing about delta to keep in mind, if you double it that's the odds the market is estimating the underlying will be ITM at some point in the options life, but not necessarily expire there. The 45 day 373 SPY put has a delta of -.25, meaning the market is estimating a 25% chance that it will expire ITM, and a 50% chance that SPY will hit 373 at some point in the next 45 days, even if it doesn't expire there.

Now, say you sell the 373 put today, and take in $485. You could hold onto it for 45 days, assuming it expires the way you're expecting, you make $485 on ~$6k investment over 45 days. Not bad. Or, you wait 20 days. If the market doesn't move up or down, that 373 put will now have a delta of approximately -.17, and will be worth about $180. If the market goes up, it'll decay faster. Now you just raked in 62% of your expected profit over half the time. Is it worth it to take it another 25 days to take in the other 38%? You might be better off to close the trade, and repeat by selling the next 45 day put. If you can do that twice over 45 days, you'll make $610 in 45 days, rather than the original $485. Assuming you did that, the market would have to crash down to $367 in 45 days before you lost money.

I hope all of that makes sense.

Big gains aren't a crash, although April and November 2020 certainly looked dramatic.  Since 2012, according to Yahoo Finance, those are the two best months for the S&P 500, gaining +13% and +11% respectively.

I might have gotten a confused view on delta online, as your explanation is much more useful in a concrete way.  Using the puts at $260 (9%) and $280 (12%) deltas also paints a more complete picture: 9% the entire spread is covered, and 3% of the time the spread is partially covered.

There's still a gap between understanding delta and using it: I don't know where you go online to look it up.  I've been using Yahoo Finance's option chain, and an app, and Vanguard's ... none of which display delta.  Is there a free website where I can find it online?