Update: June 17 2020 – I performed a formal backtest on ERN’s option strategy as a guest-post on his blog. Check it out!
Around mid April there was some options-strategy discussion comparing laddering into exposure with 45 DTE positions (the spintwig approach) vs continuous full exposure via 2 DTE options (the ERN approach).
While my strategy is of course the spintwig approach, I publicly committed in the comments of ERN’s Escape Artist post to replicate his strategy for the balance of the month (in parallel). In this post we’ll look at the key differences between the two strategies and review the results of my trade log.
How to Trade Options Efficiently Mini-Series
AAPL – Apple Inc.
- AAPL Short Put 0 DTE Cash-Secured
- AAPL Short Put 45 DTE Cash-Secured
- AAPL Short Put 45 DTE Leveraged
- AAPL Long Day Trade
AMZN – Amazon.com, Inc.
BTC – Bitcoin
C – Citigroup Inc.
DIA – SPDR Dow Jones Industrial Average
- DIA Short Put 7 DTE Cash-Secured (coming soon)
- DIA Short Put 7 DTE Leveraged (coming soon)
- DIA Short Put 45 DTE Cash-Secured (coming soon)
- DIA Short Put 45 DTE Leveraged (coming soon)
DIS – Walt Disney Co
EEM – MSCI Emerging Markets Index
GE – General Electric Company
GLD – SPDR Gold Trust
IWM – Russel 2000 Index
- IWM Short Put 7 DTE Cash-Secured
- IWM Short Put 7 DTE Leveraged
- IWM Short Put 45 DTE Cash-Secured
- IWM Short Put 45 DTE Leveraged
- IWM Long Day Trade
MU – Micron Technology, Inc.
QQQ – Nasdaq 100 Index
- QQQ Short Put 7 DTE Cash-Secured
- QQQ Short Put 7 DTE Leveraged
- QQQ Short Put 45 DTE Cash-Secured
- QQQ Short Put 45 DTE Leveraged
SLV – iShares Silver Trust
- SLV Short Put 45 DTE Cash-Secured
- SLV Short Put 45 DTE Leveraged (coming soon)
SPY – S&P 500 Index
- SPY Long Put 45 DTE Optimal Hedging
- SPY Long Call 45 DTE
- SPY Long Call 730 DTE LEAPS
- SPY Short Put 0 DTE Cash-Secured
- SPY Short Put 0 DTE Leveraged
- SPY Short Put 0, 7, 45 DTE Leveraged Comparison
- SPY Short Put 2-3 DTE M,W,F “BigERN Strategy” (guest post)
- SPY Short Put 7 DTE Cash-Secured (coming soon)
- SPY Short Put 7 DTE Leveraged
- SPY Short Put 45 DTE Cash-Secured
- SPY Short Put 45 DTE Leveraged
- SPY Short Put 45 DTE Leveraged binned by IVR (coming soon)
- SPY Short Vertical Put Spread 0 DTE (coming soon)
- SPY Short Vertical Put Spread 45 DTE
- SPY Short Call 0 DTE Cash-Secured
- SPY Short Call 0 DTE Leveraged
- SPY Short Call 45 DTE Cash-Secured
- SPY Short Call 45 DTE Leveraged
- SPY Short Straddle 45 DTE
- SPY Short Strangle 45 DTE
- SPY Short Iron Condor 45 DTE
- SPY Wheel 45DTE
- Making Money in Your Sleep: A Look at Overnight Returns
- A Bad Case of the Fridays: A Look at Daily Market Returns
T – AT&T Inc.
TLT – Barclays 20+ Yr Treasury Bond
TSLA – Tesla, Inc.
USO – United States Oil Fund
VXX – S&P 500 VIX Short-Term Futures
- VXX Short Call 45 DTE Cash-Secured
- VXX Short Call 45 DTE Leveraged
- VXX Short Vertical Call Spread 45 DTE
VZ – Verizon Communications Inc.
As the saying goes: “pics, or it didn’t happen.”
Let’s dive in!
While saying I’m going to report the results is a good excuse to try something new and deviate a bit from my strategy, there are unfortunately not enough data points available in the span of 2 weeks to generate statistically-significant results or draw meaningful long-term conclusions. With that said, there are some functional considerations we can review to see if there are any pros or cons to the strategies and scenarios where each may by better suited.
When we have capital dedicated to generate returns we want all of it working all the time.
Consider two portfolios that both have 1M dedicated for deployment. In one portfolio we implement the spintwig strategy, laddering 15% of available capital per day. In the other portfolio we employ the ERN strategy, allocating all available capital. Over the span of 21 days capital allocation may look like this:
In this example the spintwig portfolio averaged a 44% capital utilization rate while the ERN portfolio has 100% capital allocation. That’s a significant inefficiency of the spintwig approach!
Should we increase the capital allocation when laddering by a factor of 1 / 44%, or 2.27x, to bring us to 100% average capital allocation? No.
While utilizing a 34% (15% * 2.27) allocation when laddering will yield an average capital utilization of 100% in this example, it also far exceeds the risk profile. If 100% of spintwig’s capital represents 30% of the portfolio, 238% allocation, incurred on day 16, represents 71.4% of the portfolio.
How about if we arbitrarily pick a number between 15% and 34% to strike a balance between the speed of ramp up and exceeding capital allocation guidelines? Unfortunately that won’t work. Suppose the VIX contractions on day 6 or 17 never happened and we relied solely on theta decay to push positions into profit targets? In a worst-case scenario we could end up with 21 positions on at the same time. Utilizing “just” 15% will equate to 315% capital allocation. The 15% allocation is arguably too high!
What about a variable number that dynamically determines position sizing at order entry based on market conditions? That could work, but it requires knowing where the market is headed as opposed to where it has been. My crystal ball is cloudy today. In this example it just so happens 44% is the average utilization during this period of time. It’s anyone’s guess what the utilization will be next week.
In reality, 15% is the arbitrary number that was picked to strike a balance.
Winner: ERN portfolio
Neither the spintwig nor ERN portfolios have their capital sitting around in cash but instead have it allocated in productive ways via marginable securities (ignoring a nominal cash buffer for drawdowns / losing trades to avoid incurring margin interest). Thus, any options trading in these portfolios is performed on margin and by definition is levered.
The spintwig approach targets 20-30% of the portfolio (1.2x-1.3x leverage) while the ERN approach targets 100-125% of the portfolio (2-2.25x leverage).
Leverage is calculated as: notional portfolio exposure to market / net liquidation value of collateral.
Said another way: consider two hypothetical $1M portfolios. The spintwig portfolio aims to have up to 8-12 short SPY options open totaling 200-300k in exposure (one 260 SPY PUT = 26k notionally). The ERN portfolio aims to have up to 3-5 short SPX options open totalling 1-1.25M in exposure (one 2850 SPX PUT = 285k notionally).
I’ve written about the impacts of capital allocations north of 20-30%. However, that data is based on 16 delta options (1 standard deviation) in a cash-based account. The options written in the spintwig and ERN portfolios are generally around the 5 delta mark (2 standard deviations) and have the cash allocated in marginable securities. How do these two differences impact the maximal amount of capital that can be safely deployed without risk of blowing up the portfolio in a 2008-like market?
Great question! I unfortunately don’t have the data to answer definitively but I’ll make an educated guess that it’s higher than the 20-30% I’m using. This is why I’m okay with the occasional over allocation of capital via the 15% ladder approach.
Bear in mind the portfolio risk profile and drawdowns caused by down markets can vary based on the margined securities. For example, using bonds or a juiced-up equivalent via Yield Shield assets will respond differently than using securities representative of the Total US Broad Market.
All this to say, the greater the leverage / capital allocation the greater the absolute returns and risk.
Speaking of marginable securities, the spintwig portfolio has its assets invested in the Total US Broad Market and the ERN portfolio has its assets invested in various elements of the Yield Shield portfolio.
This means the spintwig portfolio is 100% equities. What does this do for us? It allows positive P/L to be deemed outperformance over the benchmark in an absolute sense. Pretty straight forward.
Compare this to the ERN portfolio, held predominantly in bonds and bond-like equities. The portfolio itself returns less than equities but total return is boosted by options writing with significantly higher capital allocation. The less risky margined securities combined with greater capital allocation work in tandem to earn returns comparable to, or in excess of, an all-equity portfolio.
What about risk? The spintwig strategy has double exposure to equities (marginable equities + options on equities). The ERN strategy had bond-like instruments that have high(er) correlation to equities + 4x capital allocated to options on equities. It’s a wash – both portfolios have a similar amount of notional equity exposure.
When the market tanks the spintwig portfolio has a few additional tricks up its sleeve. Let’s look at 3 use cases where longer-dated options outperform in a downturn.
Consider a sharp drop followed by a recovery a day or two later. The spintwig strategy has around 24 days (45 DTE opening – 21 DTE closing) for things to improve vs just 2 in the ERN strategy.
In fact, there was study done that looked at selling 7, 30 and 45 DTE at-the-money SPY puts from March 9 2009 through August 2018 (ie: cherry picking the best time to be selling puts). The 7 DTE options were held to expiration (similar to the ERN strategy) while the 30 and 45 DTE options were closed at 21 DTE (spintwig strategy).
There were 24% more losing trades when selling 7 DTE positions compared to selling 45 DTE positions and managing at 21 DTE!
In fairness this isn’t apples to apples. 2 DTE is not 7 DTE and 50 delta puts are different than 5 delta puts, but I think it paints enough of a picture to say near-term volatility (whipsaw) can be smoothed out by adding time.
Whipsaw Winner: spintwig portfolio
Withstand Pullbacks / Larger Drops Less Likely
One argument against holding longer dated options is being stuck in the position for potentially much longer while the market is in a downturn. If there’s a sharp market drop the 2 DTE strategy will take it’s lumps all at once then quickly move on collecting more premium in an elevated VIX environment as the next set of contracts are written a day or two later.
While this is an accurate statement, the 45 DTE strategy can also reap the same benefit of increased premium as positions are laddered in. Another feature of the 45 DTE strategy is substantially more resilience to market sucker punches and down trends.
A 5 delta position at 2 DTE equates to roughly 1.7-2.7% OTM with VIX around 12.50 whereas a 45 DTE option at the same delta equates to roughly 10-11% OTM. That’s a significant difference in runway!
Let’s look at declines in the S&P 500 from Dec 31, 1945 through Dec 31, 2018
By using 45 DTE 5 delta options we’re insulated from all the 5-10% decline events. Of the 29 10-20% decline events, the average decline was 13% over the span of 3 months. That’s slow enough for the runway to withstand the downturn.
To begin incurring damage with the 45 DTE positions the market would have to “correct” within ~24 days. Certainly an event that has happened more than once, but less probable for sure. Even in waterfall-like declines, the fall is jagged, not a smooth line straight down.
If I see tanking action followed by a small blip up (before an unknown but potentially continued fall), you bet I’m going to close those positions and re-open at lower strikes / higher IV. If after a week or more into a trade I’m hovering around neutral or even slightly down, I’m taking it off and resetting the clock. You can see in my tradeog I did that with a few of the call positions I wrote.
Pullback Winner: spintwig portfolio
Suppose we do encounter a correction in ~24 days. This sets us up for two things:
As we continue to ladder the positions the increasing VIX is allowing us to collect more premium and write options greater than 10-11% OTM, further insulating us from losing trades and offsetting the losses.
When the market drops that fast I’m inclined to BUY some 45-50 delta (near or at the money) SPY calls in an attempt to capture some of the recovery. Of course, a 10% drop could be the beginning of a continued fall to, say, 40% off market highs. If that’s the case then the money in the calls is likely lost. However, the odds are in our favor the market won’t decline further still.
Looking again at the S&P 500 decline data, the likelihood of a 10-20% drop turning into something worse is “only” a 27.5% (11 / 40) chance. A roughly 3 out of 4 chance of being right sounds like good odds to me.
Here’s a table of drawdowns greater than 10% from Jan 1, 1990 through Jan 1, 2018, depicting drawdown duration and recovery period.
It appears the recovery time is reasonable – a 90 DTE call option should be able to do the trick.
The ERN portfolio has very few opportunities to capitalize on a down move other than writing more contracts in the next day or two.
Downswing Opportunity Winner: spintwig portfolio
We know there’s a significant inefficiency with the spintwig approach when it comes to capital utilization as compared to the ERN approach. However, we more than make up for it through increased capital efficiency.
I wrote about capital efficiency in part 3 of my options trading series and will reuse a chart that drives this point home.
By managing longer-dated positions early I am able to improve the efficiency of capital by more than 2.27x, matching or beating the performance of the ERN strategy while exposing less than half as much capital to downside risk (or exposing the same amount of capital to downside risk for less than half the time, depending on how we want to look at it).
We can see this by looking at the ROC (return on capital) column in the trade log. Nearly all the positions were opened with a ROC of 1.2-1.9%. By managing early ROC is significantly boosted. Looking at the last trade in the log, that position was opened with 1.2% ROC. 50% max profit was reached in less than 2 hours (10:18.43 AT ET open, 12:12:44 PM ET close). My trade log doesn’t include timestamps, so the ROC is actually more than the 4x that’s displayed.
Winner: spintwig portfolio
The spintwig and ERN option strategies are simply fun names for strategies that seek to accept vega (VIX expansion) risk while managing gamma risk (spintwig) and accept gamma risk while managing vega risk (ERN). Consider this a survey of nuances and hedging tactics associated with each approach.
Both strategies are profitable, repeatable approaches to options trading. In fact, I made more in absolute terms via the ERN approach than I did with my own strategy. That being said, I was also taking on significantly more risk by way of far higher capital allocation and due to my marginable securities being held in SPY equivalents. Part of the reason I’m posting this now rather than the end of the month is I wasn’t comfortable continuing the experiment at those levels of risk. I played with fire and didn’t get burnt. I intend to keep it that way 🙂
Thoughts, feedback, questions, constructive criticism? Share in the comments below.