How To Trade Options Efficiently: Part 2
In this post we’ll take a look at the utilization of leverage, capital allocation, overstatement of delta premium, overstatement of duration premium and tax-efficient scaling.
Looking for the basics? Check out Part 1. Part 3 focuses on trade occurrences, capital efficiency and the Micro e-Mini Futures product.
Let’s get started!
Leverage is the double-edged sword that magnifies both gains and losses and involves extending yourself beyond your means. There are a couple of ways to approach it.
The Kelly Criterion, a mathematical concept that is “growth optimal” and designed to achieve the largest value as fast as possible while throwing all volatility concerns out the window and guaranteeing bankruptcy is avoided along the way. At least, that’s how it’s supposed to work in theory. In theory, theory and practice are the same. In practice, they are not. From an investment perspective this behavior is described as seeking the highest return, period.
An alternative approach is seeking the highest risk-adjusted returns. This is where an investor considers both return and volatility and seeks the highest return per unit of risk.
Let’s look at the Sharpe Ratio, a metric that quantifies risk-adjusted returns, for a leveraged and non-leveraged (cash secured) option strategy on SPY:
In this scenario using leverage widens the range of sharpe ratios. That is, it amplifies the conservativeness of lower-risk strategies such as selling 2.5-delta and 5-delta positions as well as amplifies the volatility of higher-risk strategies such as 50-delta positions.
Winner: select the strategy that aligns with your risk and return objectives.
When selling options, how much of your capital should be at risk? Well, it depends on the underlying, the delta used, exit strategies, what the margin capital is invested in and many other variables.
Below is a study that sold a short put on SPY each trading day from Jan 3 2007 through July 26 2019. Margin capital was invested in 3-month treasury bills (i.e. same as cash). The backtest was designed such that max margin utilization touches just under 100% (i.e. within $100 of the account blowing up). With the ceiling identified, average margin utilization was then calculated.
By designing a backtest in this fashion, average margin utilization serves as a ballpark figure for max margin utilization.
Winner: depends on the strategy and underlying
Overstatement of Delta
We learned in part 1 that delta is an approximation of probability of profit (POP). It can be depicted thusly:
It is known that implied volatility (IV) is typically overstated, per this COBE publication (see page 3).
Is IV overstatement consistent across all strike prices or is there a range of deltas that can exploit this attribute better than others?
Based on a TastyTrade study that looked at 10,000 SPY options from 2005 through 2018, it appears IV overstatement is not evenly distributed across deltas.
This is consistent with my own research on SPY puts and calls. We can see that the win rate on hold-till-expiration short put trades is higher than expected across the board while the win rate on hold-till-expiration short call trades is lower than expected in some scenarios.
Winner: overstatement of volatility tends to occur more heavily toward puts
Overstatement of Duration
We also learned in part 1 that volatility describes how far an option moves within a given span of time. The farther out in time we look the greater the possible price range.
Similar to the overstatement of delta, we ask the same question of duration: is overstatement consistent across all option durations or is there a duration range that can exploit this attribute better than others?
Asked another way, do we get more bang for our buck using short-dated options, longer dated options or does duration make no difference?
Based on a TastyTrade study that compared 1, 2, 4 and 12-week timeframes against actual SP500 movement from 2004 through 2018, it appears longer-dated options exhibit a greater overstatement of movement.
The study doesn’t speak to LEAPS. I suspect this could be due to the fact implied interest rates have been less than that of SPY dividends, causing SPY LEAPS to perform comparably to 3-month options (i.e. until the ex-dividend date).
When we factor in the duration findings in part 1, options closest to 45 DTE appear to remain the sweet spot.
Winner: closest to 45 DTE
Throughout this series there has been no mention about account growth or taxes. Is there an opportunity to scale trades and improve tax efficiency other than trading more contracts per position and performing these trades in a tax-sheltered account?
There are three instruments that, based on the mechanics discussed, perform identically:
- SPY – this is an ETF that tracks the S&P 500 index
- /ES – this is the S&P 500 index futures and has a notional value of five (5) SPY contracts
- SPX – this is the S&P 500 index and has a notional value of ten (10) SPY contracts
SPY option profits are treated as short-term capital gains. Pretty straight forward.
/ES and SPX option profits are treated as 60% long-term capital gains, 40% short-term capital gains per Section 1256 of the IRS code. Check out the Ultimate Guide to Taxes in Early Retirement to learn why having a portion of the gains classified as long term is beneficial.
Due to the unique and individual nature of tax planning, I won’t get into calculating when a trader should transition from SPY to one of these other instruments.
It’s also worth pointing out the costs to trade options on futures and indices are different than that of standard ETFs. You’ll want to compare, and in some cases negotiate, pricing on these types of trades.
Using leverage may come with additional friction costs as well as increased risk. However, the return per unit of risk may be outperform a non-leveraged strategy depending on the underlying. A comprehensive backtest will help traders identify the approach that aligns with their risk and return objectives.
Determining max capital allocation is best performed by running a backtest on a given strategy and underlying. Allocate too much and risk blowing up in the next major downturn. Allocate too little and risk leaving money on the table.
Puts on SPY tend to have a higher win rate for a given delta than calls on SPY.
Options expiring in 30-90 days tend to have a higher win rate than options expiring in a week or two.
Trading options /ES or SPX as can improve tax efficiency of the trading strategy.
Check out the final part to this series which covers trade occurrences, capital efficiency and Micro E-Mini futures.
Also, see how other data-driven folks like Big ERN trades options. I’ve even backtested his strategy.
May 8, 2019 @ 3:06 pm
Great series of posts. Here are a few more questions:
1. How exactly was allocation calculated?
2. How was “percentage of delta overstatement” calculated?
3. How do you position size in your trading? Do you trade as an overlay on top of marginable securities?
May 8, 2019 @ 11:32 pm
Welcome back Mark 🙂
1. My understanding is allocation was calculated as a % of notional portfolio value with the portfolio being held in cash. I.e. cash-secured puts.
2. It’s the ratio of estimated volatility and realized volatility charted in 10-delta increments.
3. Yes. I ladder in ~15% of my available capital (defined as 20-30% of notional value of my portfolio collateral) per day. The portfolio is held in SPY equivalents plus a nominal amount of cash to buffer for losses. More details of the mechanics are in the part 4.
May 9, 2019 @ 9:33 am
1. As an example, how would you determine a 30% allocation for SPY at 290?
2. Are you sure? The caption on the slide says nothing about volatility. In fact, none of the slides in that segment mention volatility. The summary reads “in this piece, we explore the overstatement of price moment [sic] based on how far out of the money options are based on their delta values.”
May 9, 2019 @ 11:57 pm
1. I would define it as 1 SPY 290 position held in a portfolio consisting of 96.6k in cash
2. I’m sure :). Price movement [over time] is the definition of volatility. We agree the edge in selling options is the fact option premium is overstated. That is, implied volatility is higher than realized. The chart suggests the overstatement is not consistent across the board but is concentrated, or even understated (i.e. having a disadvantage as opposed to an edge), depending on the delta traded.
May 10, 2019 @ 9:16 am
1. On 5/8/19, the SPY 301/268 (~16 delta) strangle sold for $2.94 (yesterday was $2.93 for 44 DTE). If you collect 50% of that in 22 days, then that’s $293 * 0.5 / 22 = $6.66 per day * 365 days/year = $2,431, which is ~ 2.5% annualized return on this $100,000 account. The graph for 30% allocation shows roughly a 65% annualized return over 11 years. Does this add up?
2. I don’t think that’s the case. I watched the segment again and I don’t didn’t hear any talk about volatility. Here’s my guess at what they did:
–Every trading day from 2005-present (stated to be 13 years), record option closest to 10-50 delta (by increments of 10).
–Score 1 (0) for option ITM (OTM) at expiration.
–Calculate A = total score / total occurrences
–For each delta, calculate |actual – expected| / expected.
As an example, consider the 30-delta puts. If A = 19.5% then |19.5 – 30| / 30 = 35% overstatement.
May 11, 2019 @ 7:41 pm
1. Great catch! No, it doesn’t, even if they’re using 30% of available buying power as opposed to 30% notional. Using napkin math that would be a 5x boost on the 6.66/day bringing annual return to ~12.15%. Rule of 72 suggests it takes ~6 years to double your money at that rate. Coming from what looks to be 500k in 2009 and almost tripling to 1.4M in 5 years doesn’t seem right. Plus, the 293 in premium collected should be cut in half to reflect the roughly 50% lower NAV of SPY back in those years.
This definitely needs some peer review!
2. Suppose your hypothesis is right. Since they’re talking about premium overstatement / collected and P/L (1:00 in video), how does that get factored into the boolean ITM/OTM calculation?
May 12, 2019 @ 11:54 am
2. Good question. Reading closely on Slide 3, “premium is overstated” could be one point and “different deltas are histocially more/less overstated” could be another. Premium is then brought into play on Slide 5 where they actually tabulate average PnL.
January 17, 2020 @ 2:46 pm
If you are only using ~30% of your margin(your notional exposure is ~1.5?) why are you trading options? Seems like buy and hold would be more tax efficient and get you just as good of a return.
January 27, 2020 @ 6:57 pm
I agree with you completely. Several months after this post was published and I had more data I stopped trading SPY options for exactly that reason. Risk-adjusted and total returns are superior for buy/hold or basic asset allocation vs a systematic option strategy. I may dabble when VIX >20, but I’ve largely stopped.
September 11, 2022 @ 10:24 pm
You can’t do /ES, SPX, or MES on robinhood right?
September 12, 2022 @ 1:11 pm
Off the top of my head, I’m not sure. Might need to call them to find out.