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Old 08-13-2011, 05:12 PM   #21
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Yes, very important. When I traded some 'naked' puts, I preferred to use the term "cash-covered" puts. Maybe your broker lets you cover them with margin, but don't lose sight of the fact that the full amount of money is behind the trade. You could have that money working in other investments, so you should use the full amount of your 'cover' as the denominator in your yield calc.

A friend of mine figured he made an 'infinite' return when he sold an option, then bought it back at a lower price. Selling an option ties up the capital it would take to own the underlying. I don't think I convinced him, because he liked his view better!

-ERD50
I'm using the margin from my buy and hold index funds as collateral for my naked puts. So technically you could say I'm selling puts on margin since I'm increasing my overall risk during times when the market drops and increasing my return when the market rises. I would never use this margin for anything else so there's no opportunity costs involved.

I do agree with you that I need to use the full amount for the sake of calculating a return just so it can be compared to other investments fairly, and that's what I do.
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Old 08-13-2011, 06:34 PM   #22
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Can you explain this sentence to me, please? If I was sitting out some weekends, then I wouldn't be trading mechanically. I would be trading based on whether or not I thought that particular week would be a good week for my trading method. Since I'm not doing that, what should "be controlled in the benchmark"?
If you were sitting out some weekends (which you are not) for no apparent reason, then, IMO, an adjustment to the benchmark would be necessary. The way you are implementing your stategy and the way you are calculating the benchmark are entirely consistent. I just wanted to make sure I understood clearly what you meant by mechanical.

I guess the real test of this strategy will be how it performs in a strongly rising market, e.g., Sep 2010 until Feb 2011 (I would investigate this period as fully as possible). I think ERD50's suggestion of using the VIX (for which data is readily available) to estimate put prices is an improvement upon using a constant percentage premium. Of course the VIX is for 30-day options, so it's still not perfect.

Depending upon how your backtest spreadsheet is set up, perhaps you could vary the put premium and find out what premium would make the outperformance of the put writing strategy disappear. Then calculate the implied volatility from this premium.
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Old 08-13-2011, 07:06 PM   #23
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I would assume that in a strongly rising market, my strategy will under perform but that doesn't bother me for 2 reasons.
#1) The market doesn't rising strongly for long periods of time very often.
#2) I'm using this strategy to trade on margin when I would not use this margin for any other reasons, so even when the market is rising sharply I will still make more money than I would if i wasn't making these trades at all even though the trades themselves will probably under perform the overall SP500.

The SP500 was +26.5% in 2009 which is a pretty strong market. My back test shows that my weekly puts would've returned 36.2%. Because you asked and because you now have me interested, I'll back test Sept 2010-Feb 2011 and report back shortly.
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Old 08-13-2011, 07:17 PM   #24
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Well that didn't take long

SP500............+19.4% not including dividends
Weekly Puts...+15.1%

The amount of under performance in a strong market really depends on whether its a quick and steady upward market or an explosion upwards in just a few of the weeks.

If the market climbs a steady 1-2% every week for, lets say 5 months, it will be a great 5 months but the weekly puts will keep up. If the market has 2-3 weeks where it shoots up 7%+ at a time, then the weekly puts will under perform, but for every single week that the market does anything other than go up more than 1.5-2%, the weekly puts outperform and there are a lot more of them.
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Old 08-13-2011, 07:24 PM   #25
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Well that didn't take long

SP500............+19.4% not including dividends
Weekly Puts...+15.1%
What was the average put premium (percent of underlying) during that period? Did you use a constant percentage?
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Old 08-13-2011, 07:43 PM   #26
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Yes, I used a constant 1.5%. I believe that's a conservative number based on my experiences real time. The VIX is relatively high right now so obviously the premiums are higher. The last 2 weeks since the craziness started I got 2.05% and 1.88% which is 37% and 25% higher premiums than my avg number respectively.

Personally I prefer when the volatility is lower. I collect less money in premiums but there's a better chance that I will keep the entire amount.

I don't think this will be the case, but if my assumed 1.5% avg premium turns out to be too high, then obviously my back test numbers will be no good.
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Old 08-13-2011, 07:55 PM   #27
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Yes, I used a constant 1.5%. I believe that's a conservative number based on my experiences real time. The VIX is relatively high right now so obviously the premiums are higher. The last 2 weeks since the craziness started I got 2.05% and 1.88% which is 37% and 25% higher premiums than my avg number respectively.

Personally I prefer when the volatility is lower. I collect less money in premiums but there's a better chance that I will keep the entire amount.

I don't think this will be the case, but if my assumed 1.5% avg premium turns out to be too high, then obviously my back test numbers will be no good.
Assuming the puts are at-the-money (is that correct?) a 1.5% premium using Black-Scholes yields an implied volatility of nearly 27%. This is higher than the highest value of the VIX over that time period , and considerably more than the average VIX over that time period.
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Old 08-13-2011, 08:14 PM   #28
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Heres the formula I use:

Assume that I sell one SPY put. I receive $2 in premium and the stock price is 120.
If the put expires worthless I make $200. If I was forced to buy the stock it would cost me $12000 so I divide $200 by the $12000 I was theorectically tying up. So my return is 1.67%. This is similar to buying 100 shares of SPY for $120 for a total of $12000 and then selling it for a $200 profit.

Technically I never have to put up the $12000 because I buy the put back before it expires if its not going to expire worthless and Im not technically tying up a full $12000, but thats the only formula I can come up with for return.
I have been writing calls and puts for quite some time. The doubling of the VIX last week had me write many times my normal one or two a month.

I try and look at the annualized return. I believe the correct formula for a cash secured put is premium/(strike-premium) * 365/days to expiration + cash*MM return. The second term is near zero and can be ignored although it didn't use to be. About 25% of one of my IRA is now fully committed to cash secured puts.

In the case of puts written against margins, I am not sure how to calculate the return. I'm like utrecht with margin rates so high, I'd never use margins so it doesn't seem appropriate to treat it the same as cash secured puts. On the other hand ERD50 is right it isn't exactly free money, something that would be very obvious if the market crashed.

Finally, one difference is I write options on individual stocks rather than indexes. As a general rule I only write puts at stocks I am happy to own at specific price. However, the other reason was I found that if I wanted to have exposure to 120K worth of puts that I was better off writing puts on 3 or 4 big names stocks than SPY despite the higher transaction cost.

However, when I just looked at the premium for SPY I realize this is no longer the case at least for at the money options. People are desperate for insurance I am happy to write contracts at for the right premium.

So my question to ERD and Utrecht is do you guys actually own SPY? The reason I ask is that SPY has the highest expense ratio of the ETFs because the structure is oldest. I own SCHB, and VB (large cap) and VTI but no SPY. If I wrote a call on SPY would that be considered a covered call? I am guessing not.
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Old 08-13-2011, 08:35 PM   #29
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About 25% of one of my IRA is now fully committed to cash secured puts.
I was doing this, and one day I got frightened.

If I own stock, fund, or ETF and something wonky goes on at my broker, they just hold the paper records for me, and I should be fine. I still own the stock, fund, or ETF.

But when the put is cash-secured, I ended up having a lot of cash sitting in the account. I started to get worried about the level of FDIC, XYZZ insurance. It scared me to think that I'm in 'risky' equities, but might lose a big chunk of money that was sitting in 'safe cash'. Maybe paranoia on my part, but with the problems in banking and other financials, I was concerned. I've switched to doing covered calls (synthetic equivalents IIRC), so most of the account is in equities (plus I earn divs).

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So my question to ERD and Utrecht is do you guys actually own SPY? The reason I ask is that SPY has the highest expense ratio of the ETFs because the structure is oldest. I own SCHB, and VB (large cap) and VTI but no SPY. If I wrote a call on SPY would that be considered a covered call? I am guessing not.
Yes, I own SPY and sell covered calls against it. I occasionally buy a call, depending upon my gut feel and testosterone levels.

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However, the other reason was I found that if I wanted to have exposure to 120K worth of puts that I was better off writing puts on 3 or 4 big names stocks than SPY despite the higher transaction cost.

However, when I just looked at the premium for SPY I realize this is no longer the case at least for at the money options. People are desperate for insurance I am happy to write contracts at for the right premium.
I used to do ~ 10 stocks rather than SPY. It seemed to make sense mathematically (something about the sum of the variance of ten stocks versus the sum of the variance of 500 stocks, but I had wine with dinner, so that's as far as I'll go). It seemed to work, for a while... then it just seemed getting hit by one mis-behaving stock here and there was driving the averages down. Maybe that would regress (progress?) to the mean after a while, but I didn't want to see my profits dwindle away. It's also a lot more work to trade 10 stocks than one index.

Plus with the liquidity of SPY options, I'm more open to a market order, which saves a few bucks. Spreads are pretty low, and though I usually do a limit, sometimes it goes the wrong way, I back up and reset my limit and would have been better off with a market order. Probably averages out.

-ERD50
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Old 08-13-2011, 08:48 PM   #30
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Assuming the puts are at-the-money (is that correct?) a 1.5% premium using Black-Scholes yields an implied volatility of nearly 27%. This is higher than the highest value of the VIX over that time period , and considerably more than the average VIX over that time period.
The puts are slightly in the money. I dont know enough about implied volatility to comment on that so I wont. What I do know is the amount of premium Ive been getting the past 14 weeks and the amount I got in paper trades before that.

VIX was ~25 at the end of July which is about the avg isn't it?. I got 1.52% the last week of July.
VIX was 32 the first week of August. I got 2.04% (I said 1.88% earlier but was looking at the wrong number).

As I said, I dont know that much about implied volatility or calculating options prices or a lot of that technical stuff which is why I asked the original question about how realistic my back test is. I'm using real life prices that I'm seeing in real time.

Are the premiums I just quoted out of whack according to whatever formula you are using?
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Old 08-13-2011, 08:55 PM   #31
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So my question to ERD and Utrecht is do you guys actually own SPY? The reason I ask is that SPY has the highest expense ratio of the ETFs because the structure is oldest. I own SCHB, and VB (large cap) and VTI but no SPY. If I wrote a call on SPY would that be considered a covered call? I am guessing not.
If you owned SPY and wrote a call against it, it would be considered a covered call just like any other stock. Since you said you dont own SPY if you write a call its an uncovered call which is a whole different animal. I own VTI, not SPY, but my strategy has nothing to do with writing covered calls or wanting to own the stock. Having said that, I realize that selling naked puts and writing covered calls has the same risk / reward profile.
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Old 08-13-2011, 09:10 PM   #32
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I try and look at the annualized return. I believe the correct formula for a cash secured put is premium/(strike-premium) * 365/days to expiration + cash*MM return. The second term is near zero and can be ignored although it didn't use to be.
Is this a formula to calculate the return of an option trade if all goes well to compare it to other possible trades? Your formula doesn't take into account what actually happened. I was talking about a formula for the actual return after the position is closed.
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Old 08-13-2011, 09:36 PM   #33
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The puts are slightly in the money. I dont know enough about implied volatility to comment on that so I wont. What I do know is the amount of premium Ive been getting the past 14 weeks and the amount I got in paper trades before that.

VIX was ~25 at the end of July which is about the avg isn't it?. I got 1.52% the last week of July.
VIX was 32 the first week of August. I got 2.04% (I said 1.88% earlier but was looking at the wrong number).

As I said, I dont know that much about implied volatility or calculating options prices or a lot of that technical stuff which is why I asked the original question about how realistic my back test is. I'm using real life prices that I'm seeing in real time.

Are the premiums I just quoted out of whack according to whatever formula you are using?
I think the put premiums you are using in your back-test may be too high.

The average VIX is more like 15% - 20% over the long-term, not 25%. If you look at the data in my link in post #27 in chart form, you can see that the average VIX over the Sep 2010 - Feb 2011 time period looks like it was about 20%, or maybe a little less. At a 20% volatility, a one week at-the-money put on SPY would have a premium of about 1.12%. This would be (1.12 / 1.5 ) = 75% of the constant premium you used in your back-test. So I would estimate that the total return over the time period in question would be closer to 0.75 x 15.1% = 11.3%. Furthermore, adding back the dividend of about 1% to the index, it seems that the put-writing strategy would have underperformed the S&P 500 by about 9 percentage points.
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Old 08-13-2011, 09:50 PM   #34
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You could very well be right. I would expect there to be a fairly big under performance in a market that is shooting straight up. However, even if I use your figures, going back to 2005, the weekly puts based on my research would still return 15% to the SP500's 1.7%. It will be interesting to see how this works out in real time over the next few months.
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Old 08-13-2011, 10:20 PM   #35
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When I write puts I also give myself some downside protection. Are you writing puts at the money? I like to have at least a 5% cushion even if I give up some premium.

Lately I have been buying quality dividend paying stocks and writing calls on them. Almost using this method as a substite for bonds....
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Old 08-13-2011, 11:22 PM   #36
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About 25% of one of my IRA is now fully committed to cash secured puts.
I've been wondering about the taxation of that. You're not paying taxes on the income now, and if it's a Roth then you'll never pay taxes. Does it mean that after age 59.5 we could write calls & puts on our Roth IRAs for tax-free income?

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Finally, one difference is I write options on individual stocks rather than indexes. As a general rule I only write puts at stocks I am happy to own at specific price.
I might be done selling calls for a few months, but these days I'm mightily tempted to sell Berkshire Hathaway puts. However I'm pretty sure that the day after I do so, Ajit Jain will get run over by a bus.

How do you handle the "bad news" put, especially if it's a surprise dividend cut? Do you shrug your shoulders and hope that the stock's fundamentals recover from the (hopefully temporary) drop in price? Or do you immediately sell to lock in a known loss?
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Old 08-14-2011, 07:43 AM   #37
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Is this a formula to calculate the return of an option trade if all goes well to compare it to other possible trades? Your formula doesn't take into account what actually happened. I was talking about a formula for the actual return after the position is closed.
Yes this was the formula for calculating the APR for writing an option that expired worthless.
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Old 08-14-2011, 08:02 AM   #38
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I've been wondering about the taxation of that. You're not paying taxes on the income now, and if it's a Roth then you'll never pay taxes. Does it mean that after age 59.5 we could write calls & puts on our Roth IRAs for tax-free income?


I might be done selling calls for a few months, but these days I'm mightily tempted to sell Berkshire Hathaway puts. However I'm pretty sure that the day after I do so, Ajit Jain will get run over by a bus.

How do you handle the "bad news" put, especially if it's a surprise dividend cut? Do you shrug your shoulders and hope that the stock's fundamentals recover from the (hopefully temporary) drop in price? Or do you immediately sell to lock in a known loss?
I hadn't thought about it with respect to my Roth which is still pretty small. However, it certainly seems like option trading and along with bonds and REIT are the right things to hold in a IRA. (Now that I've finished my 2008 capital losses I'm going to have to be much smarter/more discipline about have the right asset in the right accounts.)

For the most part I only write puts where I am happy to own the company despite any bad news at the strike price. So for instance if back the truck up level for Berkshire is 60, and my $60 put gets exercise, cause Charlie, Warren, and Ajit are killed aboard Netjet plane which crashes into a Burlington Train hauling toxic chemicals I'll simply grit my teeth and hold.

On the other hand during the crisis the dividend cuts made several banks stocks unattractive so I simply either sold the stock out right or closed out the short put position at a loss.
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Old 08-14-2011, 08:46 AM   #39
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I dont think you can sell naked options in an IRA can you?
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Old 08-14-2011, 08:54 AM   #40
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Thanks. Looks like I can complicate my asset allocation more easily than ever before...
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