Retail Broker Business Model
A retail broker such as Fidelity, Charles Schwab, Vanguard, Robinhood, tastyworks, Interactive Brokers etc. enables everyday people to participate in the financial markets.
Like any successful business these institutions are first and foremost designed to generate revenue. Similarly, like any successful business they also have risks inherent to their business model.
Let’s take a look at the retail broker business model, highlight their revenue streams and understand their risks and mitigation strategies.
Once we’ve laid out the business model let’s see if there’s an optimal approach to utilizing retail brokers to participate in the financial markets.
Contents
Background
To help us understand the business model of retail brokers it’s beneficial to have an understanding of how they’re positioned in the financial industry.
As it relates to the retail broker business model, there are 5 main entities in the financial industry:
- Exchanges
- Investment Banks
- Retail Brokers
- Trading Educators
- Retail Traders
Exchanges
This is where companies list their shares for trade. When a company decides to have an initial public offering (IPO) one of the decisions it must make is on what exchange to list its shares.
Players
There are three main players in the exchange space:
- Intercontinental Exchange (ICE)
- New York Stock Exchange (NYSE)
- Euronext (NYX)
- Chicago Mercantile Exchange (CME)
- Chicago Board of Trade (CBOT)
- New York Mercantile Exchange (NYME)
- Commodity Exchange (COMEX)
- Nasdaq, Inc
- Nasdaq Nordic (formerly OMX)
- Nasdaq Baltic
Business Model
Exchanges make the bulk of their money through three channels.
Listing fees – organizations that list shares on an exchange are charged an annual listing fee.
Trading fees – these are costs assessed when transacting on the exchanges. The primary customer of exchange trading fees are investment banks.
Market data access – exchanges capture data relating to pricing, volume, queue depth, greeks, etc. that happen on their platform(s) and sell that data as real-time market data subscriptions, historic data (think options pricing), etc. Any instance of a real-time data source, whether at a retail broker or otherwise, is paying fees to exchanges for this data.
Risks
Since everything is fee and subscription based the largest risk is a new player undercutting costs. The history of ICE, CME and NASDAQ includes an extensive list of mergers and acquisitions in order to keep the status quo.
IEX is a relatively new exchange looking to shake up the industry and currently lists Interactive Brokers (IBKR). They are undercutting the incumbents on listing and trading fees and giving away their market data for free. In fact, I’m using their API to populate dividend data, data that’s not available using Google Sheets’ finance functions, in my personal spreadsheets.
Investment Banks
Investment banks are the primary consumers of exchange resources. If you’ve ever looked up a stock and saw a stat called “Shares Held by Institutions,” these are the entities holding those shares (the balance of those shares are held by non-institutional traders such as retail traders).
In the investment bank space you’ll find JPMorgan Chase, Goldman Sachs, Credit Sussie and more.
Hedge funds, pension funds and high-frequency traders (HFTs) are peers of investment banks when it comes to customers of exchanges, but they typically don’t participate in the lending and underwriting activities of investment banks.
For our purposes of highlighting the role investment banks play in the retail broker business model we will focus on their deep pockets. In particular, the investment bank’s provision / extension of credit to retail brokers.
Retail Brokers
These are businesses that provide non-professional traders access to financial markets.
To aid in their marketing efforts, retail brokers may solicit the assistance of trading educators to gain new clients.
We’ll do a deep dive on retail brokers in the next section.
Trading Educators
These are businesses that provide marketing for retail brokers and train non-professionals how to trade.
The core tenet of trading educator operations is the IB (introducing broker) agreement. An IB agreement is a formal contract between the retail broker and the educator that defines the compensation the trading educator will receive from the retail broker for referring a retail trader.
Compensation models may consist of a flat referral bonus to the trading educator when the retail trader opens an account (common in the US) and/or a share of the commissions that account generates over a period of time (common outside the US; 20-50% commission share).
Genuine educators are regulated and are legally obligated to provide a copy of their IB agreement(s) when asked. Since it outlines how the educator is compensated it allows retail traders to identify potential conflicts of interest.
Retail Clients
These are the non-professional traders that utilize retail brokers to gain access to the financial markets.
Background Summary
If we were to draw a simplified value chain of these five entities it might look something like this:
Trader Profiles
Traders fall into one of two buckets: institutional or retail.
Institutional Traders
This is where we find traders employed by investment banks. A “typical” trader at one of these institutions may structure their trading accordingly:
- Approach
- Systematic
- Get rich slowly
- Builds a portfolio of positions
- Trades primarily on fundamentals
- Reasonable / realistic return expectations
- Risk
- Defined portfolio volatility target (eg: 10% portfolio volatility)
- Investment Banks: 10-20 long / short positions (5%-10% portfolio/position)
- Hedge Funds: over 20 long / short positions (1%-5% portfolio/position)
- Return
- Targets are contractually set; institutional traders are hired on a mandate. Market outperformance is not typically the goal; outperformance at a specific risk / volatility target is the goal.
- Generally profitable
Retail Traders
This is anyone that’s not a trader at an institution. A “typical” retail trader may structure their trading accordingly:
- Approach
- Directional
- Get rich quickly
- Day and swing trading
- Trades primarily on technical analysis and individual catalysts such as non-farm payroll data release
- Unreasonable / unrealistic return expectations
- Risk
- Undefined portfolio volatility target / “whatever necessary to make money”
- Typically only 3 positions
- Forex pair
- Speculative short on SPY / long on VIX
- The latest meme stock (currently Micron [MU] or Tesla [TSLA])
- Various “bets” using options or CFDs
- Return
- Attempts to beat the market
- Generally unprofitable
90/90/90 Rule
This is a rule-of-thumb that states 90% of retail traders lose 90% of their capital in 90 days.
The capital isn’t actually “lost,” it’s transferred to the retail broker. Let’s find out how.
Retail Broker Revenue Model
There are multiple revenue streams available to retail brokers.
Frequency, Volume and Order Size
Simply put, the retail broker makes more money the more frequently and larger we trade by way of commissions and spreads.
Commission
A fee assessed for opening and closing positions. Some fees are per trade (frequency), some are per unit traded (volume) and some are on notional value of trade (order size).
Examples include:
- Ticket – 4.95 per trade or 0.005 per share
- Option – 0.70 per contract
- CFD (contract for difference) – 0.12% monthly trade value
Spread
A “hidden” fee derived from the bid / ask spread. Let’s use some visuals to depict what this looks like in practice.
Suppose we have two traders, John and Jane, both trading at the same retail broker. Jane sells one share of XYZ and John buys one share of XYZ, both at the same time using a market order. This is a synchronous buy / sell event. The transaction looks like this:
This is the ideal situation for retail brokers. There’s no risk. The position transfers from Jane to John in a single transaction and the retail broker makes the spread. However, in practice this is the exception rather than the norm.
Retail brokers, when they make markets, have to hold positions to allow time to find matching buyers and sellers. Not every buy / sell order has a matching counter order immediately available. The process looks like this:
The risk the retail broker faces in holding positions is that the positions may change in value beyond the width of the spread, potentially causing a loss.
The broker has a few tactics to alleviate this risk:
- Don’t hold the position to make a market; pass the transaction through to the exchanges where other market participants, including other brokers / market makers, can process the order.
- Vary the duration of time positions are held while waiting for a counter order
- Narrow or widen the bid / ask spread width
- Conditionally fill orders at or near the midpoint
- Limit market-making activities to specific positions or types of transactions / orders.
- Intentionally hold the position to take the other side of the trade then sell / buy it back for a profit on top of the spread (more on this in the next section).
Financing and OTC Gain
This stream revolves around leverage and the majority of trade types placed. Ever use margin or trade derivative products such as futures, options or CFDs? This covers those activities.
Financing
A “typical” retail trader after learning they can command 10k or more in assets while using only 2k of capital may attempt to “maximize capital efficiency” by allocating all their capital in the most leveraged way possible using CFDs, options, futures, options on futures, forex pairs, etc.
Where does this margin funding come from?
When the retail broker opened shop with, say, 50 million in starting capital they approached investment banks asking for a line of credit for, say, 250 million at an interest rate around the federal funds rate / LIBOR. The retail broker then offers this credit (leverage) to retail traders at a higher rate and makes the spread.
In doing this the broker transfers risk away from their capital and to the investment bank’s line of credit. It’s the investment bank’s money at risk, not the retail broker’s.
When the retail trader incurs an unmet margin call their positions are closed. This prevents losses from occurring on the retail broker’s line of credit.
In fact, during the negotiation process between the retail broker and investment bank your margin collateral is what’s used to back the line of credit.
In essence, by funding a margin account you’re enabling a retail broker to borrow money and lend it to you at a higher rate.
OTC Gain
Short for over-the-counter gain, this is a fancy way of saying the retail broker takes the other side of your trade(s). The name came about due to CFDs being OTC products and the primary tool retail traders used to obtain leverage (before they were banned in the US after the GFC; they’re still allowed almost everywhere outside the US). That is, CFDs are contracts [for difference] between the retail trader and retail broker. They are not products traded on the market.
Using signals and other technical analysis are known by institutional / professional traders to be consistently unprofitable. Therefore, it is systematically profitable to take the other side of the retail trader’s trades with the assumption the retail trader is trading using technical analysis as a mechanic.
The same goes for event-based trading such as non-farm payroll reports. How can institutional traders consistently be right in a statistically significant way? Whisper numbers.
How exactly are retail brokers taking the other side of your trades? They acquire and hold positions then close them later and keep the difference as part of the market-making spread activity.
Therefore, by funding a margin account you are not only giving the retail broker credit to lend you money at a higher rate, you’re giving the retail broker credit to have the option to take the other side of your trades if you lose.
While writing this article I came across this handy warning label on Interactive Brokers’ UK site regarding CFD products:
Hedging
Suppose you’re one of the retail traders that makes money.
Retail brokers sort retail traders into two buckets: those that are down and those that are up.
For those that are down it’s business as usual and the OTC gain is made using the mechanics of market making.
For those that are up the retail broker doesn’t make the OTC gain and instead hedges its market-making positions by using part of its credit line to “get neutral” with your positions while it continues to make markets.
Profitable retail traders cost retail brokers the OTC gain opportunity and force them to allocate twice as much capital (allocation for the leverage / margin used by you + allocation to get neutral on your positions).
This is of course all fully automated and the other revenue streams (commission, spread, financing) continue to be earned by the retail broker.
Payment for Order Flow
Retail brokers can choose to sell part or all of their order flow to 3rd parties, particularly to high-frequency traders (HFTs). HFTs are in the business of market making and exploiting arbitrage opportunities.
The process of routing order flow and receiving payment looks like this:
Below is a [non-inclusive] table that outlines which retail brokers participate in payment for order flow (PFOF) for equities and options as of June 20 2019.
To identify what each retail broker is receiving in compensation, review their quarterly SEC 606 Report. For example, here is Robinhood’s SEC 606 Disclosure. They are making $0.26 for every $1,000 in executed trade value from most of the orders routed. 19% of all orders routed were market orders.
Revenue Model Summary
Retail brokers can make money:
- Every time we trade with a flat fee
- Proportionally with the trade volume
- Proportionally with the notional trade value
- On the bid / ask spread
- On the margin interest spread
- By taking the other side of trades
- By selling order flow
This list is not inclusive and ignores other revenue streams such as securities lending revenue splits, stock loans and the free credit balance.
Retail Broker Business Risks
Like any large business, growth is a desired outcome. Let’s explore the predominant business-model risks retail brokers face.
Attrition
Referring back to the 90/90/90 rule, 90% of clients lose 90% of their money after 90 days. Thus, roughly 90% of the retail broker’s revenue activity ceases as 90% of clients have 90% less capital from which to generate revenue.
Retail brokers spend a sizable amount of money marketing and advertising to bring in new clients to keep the revenue stream going. Typical venues include TV ads, affiliate marketing and utilizing trading educators.
Inactivity
Without activity, the broker is neither offsetting their operating costs of keeping an account open nor making a profit on it.
Some retail brokers charge inactivity or generic maintenance fees for simply having an account. This is more common on accounts that are designed to NOT have frequent trading activity and not have margin features enabled, such as employer 401k plans.
My previous employer used to foot this bill. However, in a cost-cutting measure a few years prior to my departure they decided, amongst other plan downgrades, to have the employees bear the annual Fidelity 401k plan fee of $40. Upon departure I immediately rolled the account to an institution that does not charge these plan fees.
Discussion
The “Best Client” Example
Reflecting on the financial industry value chain and retail broker revenue streams, let’s identify the hypothetical “best client” for each entity.
- Exchange’s’ best client:
- Institutions that:
- seek to purchase and research historic market data to find strategies and trends to beat the market
- trade with the highest volume and largest size the most frequently
- that seek real-time market data subscriptions to facilitate active trading
- Institutions that:
- Investment bank’s best client:
- Retail brokers that:
- generate the most line-of-credit income
- generate the most liquidity. Liquidity is generated through trade activity. The more activity, the more liquidity.
- Retail brokers that:
- Retail broker’s best client:
- Training educators that encourage retail traders to:
- maximize leverage
- day trade
- use strategies that are consistently / systematically unprofitable such as technical analysis, signals, etc.
- shift from buy-and-hold and get active
- Training educators that encourage retail traders to:
- Trading educator’s best client:
- Retail brokers that:
- pay the most per referred retail trader account opened
- offer the greatest commission revenue split
- Retail traders that:
- believe and employ / don’t research the concepts and strategies they are taught
- don’t question or are unaware of conflicts of interest
- Retail brokers that:
- Retail trader’s best retail broker:
- Commission-free trades
- No account maintenance or inactivity fees
- Provides the best price execution / does not practice payment for order flow
Ban on IB Agreements
Remember those Introducing Broker (IB) agreements from earlier? Singapore banned them in 2010. In 2016 Belgium did the same.
What does this mean for trading educators? Beyond the fact they cannot be compensated by retail brokers in these countries, its signals a potential trend in the financial industry that needs to be hedged.
Retail brokers hire trading educators as a way to defer marketing and distribution costs and optimize client acquisition. A famous marketing quote by John Wanamaker goes: “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.” By compensating trading educators after clients have been brought on, retail brokers only pay for the successful customer acquisitions.
Retail Brokers offer Trading Education
What if retail brokers want to cut out the middleman without spiking marketing and client acquisition costs?
To permanently lower client acquisition costs we need to stop having 90% of clients blow up their account in 90 days by providing trading education that at a minimum significantly delays account dissolution and at best produces successful traders.
In doing this retail brokers essentially forfeit the OTC Gain (taking the other side of losing client trades) revenue stream in return for converting their business model to a “coupon” business. That is, retail brokers train traders to maximize other revenue streams (commissions, spreads, financing through leverage, payment for order flow, etc.) while keeping their accounts funded.
Example
Among the option trader community there’s a familiar retail broker that does this: tastyworks.
tastyworks is a retail broker that performs and gives away quantitative research on options trading. This research is used to pitch active management, frequent and continuous trading and suggests implementing strategies such as SPY naked short puts and SPY vertical put spreads – strategies that have been independently confirmed to be consistently profitable (albeit less profitable than buy and hold) over the long term.
They want you to be successful, or to at least not go broke, so you can keep trading and continue to generate revenue.
The Retail Broker Business Impact of Buy and Hold
The buy-and-hold strategy is the most profitable and least expensive strategy to implement for retail traders. It is also the strategy most harmful to retail brokers’ business model. Let’s see why.
Commission
Most mainstream retail brokers don’t charge a commission to trade the buy-and-hold ETFs so the commission revenue is gone.
Spread
Buy-and-hold retail traders will buy or sell, depending on whether they’re in accumulation or decumalation mode, let’s say twice a month.
The spread on broad-market ETF products is typically a penny wide. The best case for the broker is they make the full penny twice a month per client.
Financing
Buy-and-hold investors typically don’t buy and hold on margin as there are less expensive vehicles to obtain leverage.
Financing will be limited to retail traders using margin as a cash management tool. That is, short term lending / HELOC alternative.
OTC Gain
Institutional traders don’t short the S&P 500 as a long-term strategy; they will not be trading against you on your long broad-market positions.
Payment for Order Flow (PFOF)
With each client trading twice a month on the broad-market indexes, HFTs will derive limited value / ability to pay retail brokers for order flow due to minuscule transaction volume and exceptionally narrow product diversity.
Stock Loans
The long-term buy and hold strategy is for going long. Retail traders will not be paying fees to retail brokers to borrow shares to open short positions.
Summary
While the data has suggested that some option strategies are indeed profitable over the long term, the data has also suggested that buy-and-hold indexing usually outperforms any basic options strategy with regard to both risk-adjusted and total return.
Curve fitting activities can identify options trading strategies that outperformed over a given period of time. However, curve fitting is an exercise in applied data mining and the best curve fitting strategies still underperform when taxes are taken into consideration.
The buy-and-hold strategy is harmful to the business model of retail brokers.
Retail brokers and several other entities in the financial industry have a strong incentive to promote continuously trading the most volume and largest size.
July 28, 2019 @ 9:34 pm
Thanks for the very interesting writeup, spintwig. I seem to have landed (mostly) on my feet – by luck, because it’s most certainly not by design – in my financial education journey. Started down the road with a trading educator, aborted the process a week or so down the road after smelling a rat, ran across tastyworks while blindly hunting for a way to learn these valuable skills despite the feeling that 99% of what’s offered is pure bunco, and have been trading (some might even call it “successful” – positive P&L overall, although I’m nowhere near the knowledge or income level that I want.) It’s been incredibly interesting and engaging so far, and I look forward to continuing to learn more about this world as time goes on.
The main question I have for you, though, is this: if B&H is so profitable by comparison to options – and please correct me if I misunderstood something – then why are you involved in options trading at all?
July 29, 2019 @ 3:39 pm
You’re welcome! And thank you for the idea and interest that pushed me to move this up in the queue.
Short answer: I stopped trading this month as a result of the research.
I started trading late Q3 last year as a result of BigERN’s posts and subsequently TT materials. Like yourself I was a bit skeptical – I couldn’t put my finger on 1) how they could afford to perform and deliver all this research for free and 2) how any of these supposedly outperforming strategies haven’t been arbitraged away.
On the other hand I was making a few bucks so I didn’t think to dig deeper.
It wasn’t until doing several of these backtest studies and lots of homework on the retail broker business model that things started to finally make sense. I stopped trading and any leverage I intend to apply to my portfolio – none for the foreseeable future – will be in the form of long SPY on margin as opposed to options on SPY.
July 29, 2019 @ 10:50 pm
> I stopped trading and any leverage I intend to apply to my portfolio – none for the foreseeable future – will be in the form of long SPY on margin as opposed to options on SPY.
…wow. I seriously didn’t expect that. In a way, I’m really sorry to hear it; I have quite enjoyed watching you dig into the nitty-gritty of options, and integrated a fair amount of it into (or at least used it to confirm my own biases) my own trading. I’m genuinely going to miss your good thinking and your incisive analysis. 🙁
SPY is definitely up this year… but we know that _now,_ with the usual perfect clarity. The future is a bit more cloudy. Are you absolutely sure that just being long SPY is the best answer? Not even long-dated puts for protection?
Also, a question that’s a bit more pertinent to my own trading if you don’t mind: I think I’ve mentioned that, as a veteran, I trade commission-free at TradeStation. Would your decision have been any different if you were in my position?
July 30, 2019 @ 1:08 am
There’s a lot of interest in this space and demand for continued research. I intend to keep doing studies and related posts for the foreseeable future 🙂
I’m absolutely certain. Let’s napkin math:
The most lucrative non-ITM options strategy backtested thus far is the 75% or expiration 30D SPY short put. On a 100k portfolio it yielded ~65k over ~12.5 years. Not bad. If trading was free the P/L would be around 68k. I’m ignoring the fact that the strategy P&L is unrealistically high due to the strategy breaching margin requirements several times over the 12.5 years, particularly during market stress.
Meanwhile, SPY yielded almost 119k, 75% more than the most lucrative and reproducible options strategy. For readers outside of the states the conversation ends there. For readers in the US there’s the advantage of being able to defer and/or pay lower rates on LTCG, further solidifying the argument toward buy-and-hold index.
If it was close I could see how the uniqueness of individual scenarios, broker trade fees (or lack there of), margin rates, taxes, etc. could sway the decision one way or another. However, with a ~75% outperformance for buy-and-hold there’s nothing I can think of that can make the options strategy comparable.
My decision would be the same. Free trades do make the low-risk strategies viable and revenue generating. However, even if trading for free, systematic options strategies don’t come close to buy-and-hold SPY.
July 30, 2019 @ 1:18 am
On an unrelated note, I’d like to learn more about your boat dwelling lifestyle. There are several moored and anchored across the street, not to mention many more parked at the various marinas, setup as a permanent water-based home. It was something I considered when I initially bought a house and again when I sold the house and downsized to a condo.
What’s the maintenance schedule like and how do you handle extreme weather such as hurricanes (assuming you’re in a local where they exist)?
July 30, 2019 @ 10:59 am
These days, I’m doing the RV thing – just can’t give up that mobile lifestyle. Might shift back to a boat, though; that’s always up for grabs. But I could write a treatise on both of those subjects… after 20 years aboard, I have a wealth of info (and opinions, mostly firm ones.) If you’d like, we can take that discussion off-line (just add ‘@gmail.com’ to my username).
But as a pair of synopses:
Maintenance: It Depends. Mostly on the skill sets that you have, or are willing to pick up. There are no plumbers, carpenters, mechanics, fiberglass repairmen, welders, or electricians out in the ocean (and adding the word “marine” to anything instantly triples its price), so the more you can learn, the better off you are. Costs and maintenance also go up asymptotically with boat length, so the fundamental decision is “how small of a boat can you be comfortable in?” Overall, if you start with a properly-designed, well-built boat in reasonable shape and in the 32-36′ range, you’ll have the absolute minimum of maintenance possible while having enough creature comforts (by my standards; it would be fairly sparse for most people.) After you *know* what you’ve got, and can make informed decisions for yourself, you can graduate to a larger boat if you want… but don’t saddle yourself with “making boat repairs in interesting places” (one of the definitions of cruising.) I have friends who spend half their time chasing parts from the Bahamas…
Hurricanes: It Depends. 🙂 There’s a decision universe for where you’ll be at a given time of the year that involves personal comfort and wants/needs, sailing experience, weather, climate, wind direction/strength, alternate sailing routes, hurricane zones and seasons, and the time you can allocate to making the passages (which can depend on work and other commitments – or the other way around, depending on how you’ve arranged your life.) The size of anchors you carry on board also influences everything: with my 125-lb fisherman, backed by a 66-lb and a 72-lb CQR and a few other ancillary anchors, I’ve weathered a number of direct hits in Florida (I was off the boat for most of them.) Where you are also matters a lot: if I’m in, say, Salinas (PR), I don’t give a flying f* about hurricanes. If one is coming, I’ll simply sail over to Bahia de Jobos, run the boat up into one of the narrow but deep streams, run a line from each of my cleats or winches to 3-5 mangroves, and enjoy one of the greatest shows on earth. (There’s *NOTHING* in this world like watching a 155mph eyewall pass directly over you. I guarantee that it will leave a permanent imprint on your heart and soul.)
Feel free to ping me for more, if you like. I owe you a beer or two. 🙂
July 31, 2020 @ 10:34 pm
Hi Spintwig
Thanks for your research. Great work.
I have some comments below.
> systematic options strategies don’t come close to buy-and-hold SPY.
Is this still your opinion? I am struggling to understand this when compared with other material / research that has been published. I appreciate that the research is published by potentially biased actors given the retail broker model.
I find your research particular interesting regarding the costs associated with systematic options trading.
In the above comment chain, you compared “75% or expiration 30D SPY short put” against B&H SPY to justify outperformance of B&H. Is this a fair comparison given the differing risk profiles?
> how any of these out-performing strategies haven’t been arbitraged away.
By selling options, you are harvesting volatility risk premium which is a form of structual alpha that you cannot get through simple B&H of underlying. The volatility risk premium should not be arbitraged away as it is a genuine return for the risk of volatility expansion. It is similar to the insurance business model whereby premium is overpriced, but customers knowlingly pay for peace of mind.
For this reason, systematic option strategies such as cash secured PutWrite should outperform B&H underlying long term (risk adjusted). The only instances where this would not be the case is if the volatility risk premium was negative over a prolonged duration. This would be catastrophic market failure – participants would need to be in prolonged state of denial about how negative things are, which I don’t think is possible given human tendancy to overreact (greed and fear).
In saying all this, I agree with you that all systematic trading stategies have execution costs which cannot be ignored. Also, I agree with you that B&H has tax advantages which is critical and often ignored.
It ties in to the good old passive vs active debate, which is unresolved. Can the excess risk adjusted return by an active strategy offset increased fees, yes – but most often not.
August 2, 2020 @ 6:37 pm
Hi Jordan,
Since publishing this article, new research has suggested there are indeed select strategies that come close to buy/hold and it depends on the underlying. However, they are optimized to perfectly maximize leverage using hindsight bias and ignore tax drag. Outperformance has technically been possible in very specific, narrow scenarios. The only exception is EEM, where a cash-secured strategy outperforms, and even more so when leverage is applied.
I’m open to comparing against other benchmarks. What do you suggest is a good benchmark for the “75% or expiration 30D SPY short put” strategy?
The tradeoff of lower total return for lower volatility is fitting for those who have FIRE’d as it can help mitigate sequence of returns risk. See: https://earlyretirementnow.com/2020/06/17/passive-income-through-option-writing-part-5/. I stick with the buy/hold approach and use some retail arbitrage opportunities and a small allocation to handpicked cumulative preferred shares to boost Sharpe ratio.
July 30, 2019 @ 10:17 am
Thanks for that; I didn’t have your numbers, but simply drawing a trendline through SPY performance over the last 10 years (as I did when I started this process) stuck a little burr under me that’s been itching all this time. I thought I’d be able to beat it, at least after a year or two worth of learning curve, but… that’s been looking less and less likely as time goes on. I’m going to review your research and see if I can confirm it (it’s basic enough that I don’t see where it could be wrong, but I like to have my own numbers for financial decisions), and follow the outcome where it leads me. Most likely, I’ll sell some 30-40 delta naked puts for a bit and see if I can get into SPY at a decent cost basis, for the majority of my account. I should have been holding most of it in there anyway.
The time and effort I’ve spent have not been a waste – the gain in perspective alone is worth it, and there will be times when these tools and the knowledge that goes with them _will_ come in handy – but I think I’m better suited to passive investment plus a little insurance for the bad times.
October 2, 2020 @ 3:58 pm
Hi – I’ve just come across your material and have yet to read and absorb. My Option Trading strategy has been based on the Wheel and my broad goal is to preserve capital and generate reasonably modest income.
I have a fairly large portfolio and could buy and hold several lots of SPYs. One way of generating income from this would be to sell individual SPY shares and then top up with another assigned Short Put.
I trade from Australia and its very early in the morning – my thinking may not be straight but I’d appreciate your thoughts.
Thanks for your research I will read and absorb.
October 5, 2020 @ 7:20 pm
Hi Bryan – thanks for writing. I’m not familiar with your particular income needs, portfolio construction or risk concerns, but short-dated far-OTM short puts may help alleviate sequence of returns risk.
I wrote a guest post over at BigERNs blog that dives into this strategy in more detail: https://earlyretirementnow.com/2020/06/17/passive-income-through-option-writing-part-5/
Alternatively, a balanced portfolio of stocks and cash in high-yield savings accounts (in lieu of bonds since cash is outperforming for the time being) might be the best approach.
November 23, 2020 @ 4:30 am
Hi Spintwig, thank you very much for your great work and giving away those backtests. These have really been eye-openers.
What I have asked myself: if e.g. B&H systematically outperforms buying long calls – does that not necessarily imply that selling covered calls every day is a good idea? Am I missing something?
November 24, 2020 @ 3:09 pm
As far as SPY is concerned, systematically selling covered calls has generally been an unprofitable strategy.
Sure, when shares get called away it means both the long position appreciated and all the premium was received. However, when one has to “buy back in” is where the masked loss of the short call expiring ITM becomes realized.
If the covered call was written 2% OTM and SPY went up 3%, to sell subsequent covered calls you’ll need to repurchase 100 shares of SPY which will require additional funds to be deposited into the account.
November 25, 2020 @ 4:37 pm
Would have been nice of you to name the source of that content.
November 25, 2020 @ 8:27 pm
Ah, sorry.
SPY Short Call 45 DTE Cash-Secured Options Backtest
SPY Short Call 0 DTE Cash-Secured Options Backtest