2022 Learnings

Moving into a new year, it is always good to review trading in the past year to see what can be learned. 2022 is no exception. I had a rough year in many ways, but also had many successes, and need to take away some lessons from it.

Overview

2022 was a bear market year. Coming into the year, I was trading some very aggressive, short-duration bullish options positions, despite lots of warnings of troubles on the horizon. This resulted in a big loss in January and February, until I adjusted to a more neutral approach. However, I got away from many core philosophies and still didn’t recover as well as I could have.

What didn’t work and why

My biggest losses came from three main strategic mistakes, one that was new to me, and two that I should have know better. The new one was selling short duration without an appropriate exit strategy. The old should have known better losers were trading options on individual stocks and selling calls too close to the money.

Short duration trades

In 2021 I rode the bull market with a trade that was perfect for an almost straight up market, the 7 DTE rolling put spread. I’ve written about it, and you can read about how great it worked. However, when the S&P 500 went down over 400 points in a month at the beginning of 2022, there was no defense with the strategy of rolling. Because I had so much success with selling 7 DTE put spreads, I was reluctant to admit that the strategy wouldn’t work. I wasn’t prepared for a move down that didn’t bounce back. We had plenty of warning that the Federal Reserve was going to stop pumping money into the economy and instead raise interest rates and reduce the money supply. But, I left myself exposed with lots of short duration put spreads as the year began.

I tried to fight the down moves with rolls and a variety of other tricks I’ve used over the years, but there really was no defense for short puts close to expiration in a plummeting market. As I’ve come to learn, in down markets puts can be underpriced for the risk, and short duration puts can actually be a good buy. The book “The Second Leg Down: Strategies for Profiting after a Market Sell-Off” by Hari Krishman details a number of studies to back this up.

I’ve heard from a number of people that they had success with short duration options even in 2022 by going a little further away from the current price and either holding or using stop losses to keep losses from getting too big. But, I didn’t do that. Later in the year I tried to get back into selling some short duration options and got burned again. My style of rolling is just not a good fit for short duration options.

So, as expiration approaches, there is a lot of time decay that is very tempting to take advantage of. The flip side is that to get that decay, options must be sold quite close to the current price making them susceptible to a sharp move. Short term move of several times the expected move are not uncommon, especially in a bear market. For me, the returns are not worth the risk. My temperament is just not set up for this kind of trade.

More time gives more forgiveness. Looking to reduce risk from short duration options, I’ve focused studying ways to get the most out of longer duration options. I’ve done additional research on optimal Delta for selling put spreads at different time durations to maximize Theta. I’ve also gotten back to waiting for down days to sell bullish put strategies.

The only short duration trade I’m currently doing is an opposite trade to most of my other strategies. I’m buying 1 DTE straddles, as I’ve written about in a previous post. So far, so good with that.

Selling Calls too Close to the Money

Even in a bear market, selling calls can be painful. In a bear market there are often large counter-trend rallies where calls with strike prices close to the money quickly end up in the money. Implied volatility on index options is almost always significant skewed to the downside, making calls cheaper than puts. Selling the lesser call premium tends to not be adequate for the risk of a big rally. When I combine selling calls close to the money and with fairly short duration, I set myself up to be whip-sawed back and forth, reacting to each move in ways that locks in losses each way.

Ideally, I want to have positions outside of the market moves, far enough away in time and price distance that day to day price changes have little impact on me and I can just wait for time decay to work my option prices down over time. Puts tend to have more strategies that can be profitable when selling than calls. If you don’t believe this, just try back testing short option strategies and see if you can find one where calls beat puts- I haven’t found one.

Selling Options on Individual Stocks

I’ve written a number of times about how indexes are much less likely to have extreme outsized moves than individual stocks. 2022 is a great reminder of that. Many formerly valuable stocks lost well over half their value during the year, and a number of them lost over 90% of their value. I was exposed to some of this mayhem when I sold puts well out of the money on a few that seemed like they couldn’t miss, but then did.

I completely botched a trade on a company that I really like. Generac makes back-up generators as well as systems that store and manage electricity generated from solar panels. With the electrical grid getting less reliable, people are in need of their products. So, to mix it up a bit, I sold at $20 wide put spread in the low 200s early in the year after the stock had fallen significantly and seemed to be on an upward trajectory. Despite all their success in the market, the stock slowly declined, and I found myself rolling my position down and out a few times. Then, I made the fateful decision to sell my long put of the spread and switch from a put spread with $20 risk, to a naked put with a strike price of $200, cash secured. I figured that the stock was surely at the bottom of its range, and I wouldn’t mind owning it if it dropped a little more. Then Generac announced that they were going to miss earnings substantially because of a lack of installers available to deliver and install their equipment at residences. Overnight the stock dropped 30% after previously losing over 20%. Before I knew it, I was stuck obligated to buy a $100 stock for $200. I tried to roll out, but there were no takers to make a trade. I was assigned the shares, losing $10,000 per contract on a trade that originally had a max loss of $2,000 per contract. Multiple bad ideas- individual stock risk, getting cute when tested, not accepting a loss and moving on.

I also sold puts on ARKK, the Ark Innovation ETF. It’s not an individual stock, but it is a volatile managed fund of a relatively small number of innovative companies. Again, I thought that we had seen the worst of the market drop, especially for this fund, and I sold cash secured puts in the middle of the year. Since then, the stock has fallen by half- I had about a 10% cushion to start, but that is long gone and now I have shares.

There are some others that weren’t that bad, but the conclusion is the same. Options on major indexes are much less likely to be hit by outsized moves, particularly if there is a decent amount of time until expiration and the strikes are well out of the money. That is one of my core mantras and I strayed at my own peril.

What went well

Fortunately, not everything went as badly as the trades described above. I re-discovered some strategies that I had stopped using that worked well, and started using some new strategies that I was either skeptical of or unaware of prior to putting them into practice.

Selling Long Duration Puts

I’ve sold puts well out of the money well out in time many times in the past, but the allure of big Theta from short duration started getting the best of me. Why sell at 6 weeks or 12 weeks when we can make bigger returns selling at one week? Well, lots of reasons. Short duration takes lots of effort and is much more stressful. It doesn’t take a big move to blow past strikes that have value less than a week until expiration, while positions outside of the expected move a month or more out in time are much less impacted.

With positions 4 to 6 weeks out or even more, we get more consistent results and can reduce volatility of the portfolio. When a big move happens, we can wait a few days to see if the move reverses before making any adjustments. Often it does and there is no reason to intervene.

I’ve found that I can still sell spreads with Delta values in the teens that are in their maximum percentage of decay weeks or even months before expiration. While the percentage return isn’t as high as short duration, it is more consistent and higher probability of being positive. It isn’t exciting, but that’s okay.

Put Ratio Trades

The most popular page on my site every month is my explanation of how I trade broken wing butterflies. For a while I got away from trading this, chasing some other “shiny object.” I re-started trading the strategy and got back to winning. I have been a little more opportunistic with this strategy, opening on down days to get my strikes lower with higher IV, but the trade is high probability with rapid decay. The way I trade it seems to be just far enough out in time to buffer it from the volatile weeks that have come along regularly in 2022.

I’ve also had good success with the other put ratio cousins of this trade, the broken wing condor (or 1-1-1-1), and the 1-1-2-2 trade. The common thread to each of these is that there are two competing spreads in each case. I start with a debit put spread, typically where I buy a 25 Delta put and sell a 20 Delta call which acts as protection for a higher priced and wider credit put spread at lower delta values. The wider and lower Delta valued credit spreads decay faster than the narrow debit spread, and often switch from a negative value overall position when sold to a positive value position that I can sell to close prior to expiration. This happens when the wide credit spread decays to the point that it has less value than the narrower debit spread. So, I often collect cash when I open and collect cash when I close these.

Finally, I’m seeing success in the naked versions of these trades as well. Instead of having two spreads, I sometimes skip using the low long leg of the credit spread and go with selling a naked put. This leaves me with a debit spread protecting a naked put or two below it. So I end up with 1-1-1 or 1-1-2 versions of the above trades- true ratio spreads. These have undefined risk to the downside unless cash secured, and I trade them on margin. That ties in nicely with some of my other take-aways.

Using Futures Options to Pump Up Returns

After avoiding futures for many years, I’ve really become fond of them. I avoided them because I didn’t see the strategic value of buying or selling futures contracts on an index or commodity. I was also scared by the risk of aggressive use of SPAN margin. But what I’ve found is that futures options in particular allow me to sell high probability positions for very low amounts of capital, and then allow me to buy or sell actual futures contracts to use as a hedge and neutralize overall Delta. It can get complex very quickly and a trader has to be avoid building a house of cards that could collapse in a outsized market event. But when used with care, futures options and futures themselves provide valuable tools to increase returns.

I haven’t written much about the use of futures strategies on this site because I’m still working to distil the approaches into content that can be readily applied. Risk vs reward becomes much more significant with futures options, so risk management becomes a primary consideration in every trade and isn’t something to jump into without a comprehensive understanding.

All that said, I’m finding futures options allow me ways to magnify returns and also hedge my risks. I’ll be writing more in subsequent strategy discussions, but if you look at pages on four different underlying types and four levels of risk, there’s some initial content to consider. One specific hedge trade I’ve started using, the 1 DTE Straddle, came from my futures experience.

Selling Naked Futures Options

One place where I’ve found success with futures options is selling naked options well out of the money well out in time. Because of SPAN margin, these trades don’t require much capital. They also don’t move that much because of the long duration. I’m finding trades with lots of decay and really seeing the appeal of naked options. Long duration and low deltas cushion the positions from big day to day moves and give me plenty of warning to adjust when needed. While spreads have windows where they can be rolled for credit and other Delta values where they can’t, naked options can always be rolled out in time for credit. The issue is that some rolls are more lucrative than others.

So I finally see the flexibility and adjustability that naked options provide in defending against big price movements. The key is to manage size to keep risk reasonable.

Naked to me involves a variety of strategies from selling a single option, to selling the naked put ratio trades mentioned above. As I better define consistent management and hedging approaches to these trades, I’ll explain my naked strategies in more detail.

Using Research to Test Strategies

Finally, I’ve re-discovered the importance of doing my own research to understand trades I’m doing. I’ve shared many of my insights on this website, but I always have new ways to look at trade set-ups, impact of management, and understanding risk. I’ve written about the sources I use to research the market, and I still use the same primary approaches. I use current option tables, I do backtests, I analyze historic trends, and I model potential outcomes.

Sometimes it is easy to get caught up in what I’m doing every day and not stop and ask if the approaches I’m using at the moment are really valid. I don’t look to see if there is a better way. Research keeps me fresh, and often validates findings I’ve observed in the past, but strayed away from in my current trading. So, constantly looking at data from different strategies in different ways actually keeps my trading focused on approaches that work.

I also find that the biggest beneficiary of the studies I share is me. Writing things down to share makes me double check my work and get clearer as to what I’m doing. Sometimes in the course of providing data for a trading approach I’m doing; I realize that I could do better, and revise based on what the data says.

I also get a lot of inspiration from other sources- groups I’m a part of and sites I follow. My favorite source of inspiration continues to be TastyLive, which I often have playing in the background while I trade. I interact with a lot of other traders which also helps. I’ve written about the value of community in the past.

So my final thought is that I need to challenge myself to always keep learning and base my trading strategies focused on proven approaches with high probability of success and manageable risk.