As I tally up the results of my investing activity over the past year, one asset class stands out Above the rest – selling stock options.
For many of you that may think of options as overly speculative and risky, let me point out that some of the most revered investors in the world including Warren Buffett do a variation of the strategy that I have used.
It’s called selling put options, which fundamentally is selling insurance against a large drop in a stock portfolio – and there are a ready pool of investors willing to buy it. And like any other viable insurance business, the model works if the amount of premium paid can cover the expense and anticipated frequency of the insured event. When you sell a put option you incur the obligation to buy a counter parties stock only if it drops to a certain agreed-upon price below where it is currently trading. The obligation can be purchased for a wide spectrum of time horizons ranging from weekly contracts to several months. If the equity drops to the agreed-upon price level called the strike price, the option is exercised with a transfer of ownership. If it does not reach the strike price, the option expires worthless and a new contract can be written with more premium taken in by the put seller. The exact same strategy can be executed for strike prices above the current price and these options are referred to as calls. Conceptually, it’s fairly straightforward although there are a number of variables that need to be understood related to volatility strike price selection and timing that allow you to tailor the strategy for your risk tolerance. In Buffet’s case, he has often sold millions of dollars of long term put premium as a way to lower his cost basis on positions he wanted to own anyway like Coca Cola and Burlington Railroad. Apparently options were excluded from his famous derivatives as weapons of mass financial destruction credo as he has also been quoted as saying, “Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies”.
While I did an extensive amount of reading, in the end, I ultimately wound up hiring a “coach” to walk me through my first several months of trading. My coach as it turns out was not a professional trader but actually a second generation CPA who has been conservatively trading options for the past 15 years. This brings up another interesting point. When you peruse the retail options blogosphere (ie non-finance professionals) you will see that there is an over representation of engineers, pilots, accountants and other professions where a high degree of technical and or mathematical competence is required. Perhaps my physics background and the very quantitative nature of radiation oncology practice lends itself to this sort of investing, although you certainly don’t need a PhD in math to master the concepts.
How does this strategy compare to simply investing passively in a broadly diversified low-cost mutual fund? With the S&P index returning 19-21% (depending on dividend reinvestment) for the calendar year 2017, the strategy outperformed it by a comfortable double-digit margin. This was enhanced by the unusual fact that we didn’t have a 10% market correction the entire year. In discussions with my coach, in a typical year where we do have a correction, the strategy would produce a return in the low 20% range . Particularly noteworthy is that the strategy can produce these returns in a number of market conditions ranging from side ways to slowly downward drifting. Conversely, during a more severe market correction ala 2008; the losses will be more severe than if you had simply held the equity positions. Nonetheless, the option premiums are priced sufficiently to still yield a net positive return over time and makes this a viable long-term strategy.
Here are a few other factors I consider to be positives about implementing a conservative options trading strategy.
- While of course I enjoy experiencing the capital appreciation of my equity positions, the steady inflow of options premium satisfies my cashflow oriented background as an income property investor.
- The particular strategy I employ is not very time-intensive. The mechanics of putting a position on or taking one off is very straightforward and takes 5 to 10 minutes. Because our positions have such a low probability of being breached, they require little monitoring or adjusting.
- If the strategy is implemented on the major indices like the S&P as opposed to individual stocks or ETFs there is also a tax advantage. Under IRS rule 1256, 60% of your Index options profit is taxed at the long-term capital gains rate even if was earned in less than a year. For this reason, I have thus far limited my trading activities to these instruments.
Certainly there are trading cost to consider, but they continue to go down over time. Recently the popular stock market app Robinhood introduced commission free options trading on its platform which will surely apply further downward pressure throughout the industry. And while there are certainly more options specific platforms, many of the mainstream brokerage houses like E-Trade, Fidelity, etc. allow for some basic option strategies. If you already have an account with them, this provides extra leverage to negotiate your options commissions in my experience.
I should also note that it is possible to implement a variety of conservative options strategies in retirement accounts although usually it requires additional paperwork, permissions, and disclosures. With the exception of my coach, the people I have met that are actively doing this are retirees looking to generate additional cash flow from their nest egg.
If you’re interested in learning more about options, one resource I found particularly helpful was the TastyTrade YouTube channel. Run by a former professional trader who has a proprietary trading platform; there are plenty of easy to follow along visual illustrations of how options trading works. Equally compelling is his interview series with mostly people from a non-financial background who have had a measure of sustained success as retail traders using a variety of approaches. OptionAlpha.com is also another incredible free resource that covers the full spectrum of options strategies. (By the way I have no financial relationships with either company)
When you browse the options education blogosphere you will see many people making hyperbolic claims. Additionally it’s quite easy to cherry pick and highlight your best trades while ignoring your losers. In the spirit of transparency, I’m happy to show the details of my actual trades if you would like to reach out at www.AlternativeFinancialMedicine.com.
Option trading, even when done conservatively is certainly not a substitute for long-term buy-and-hold investing. The the majority of my stock portfolio is in a retirement account invested in a index fund with minimal expenses. Nonetheless when done correctly, options can be a reliable way to augment your returns long-term.