I recently published a couple of studies on two different variations of a trade that sells what many would call a “Poor Man’s Covered Put,” a diagonal trade focused on collecting income from rolling a short put day after day. After a lot of review of some different daily diagonal rolling trades using SPX puts, I’ve continued to question whether the choices for strikes and expirations I’ve been trading are optimal. Could a backtest help?
To dig into details of the trade, including suggestions for managing outlier events, check out Very Long and Very Short Put Diagonal, and Daily Diagonal Covered Put. One uses a long put with a 5 year expiration and the other uses a long put with 60 days, while both sell a short put with just a few days until expiration.
Without going into every detail of the trade, we are talking about buying a long-dated put and selling a short-dated put as a combination trade. The two options will have different expiration dates and different strike prices, which is considered a diagonal trade. The idea is that the put that was sold, the short put, will decay faster than the put that was bought, the long put. To maintain the trade, we just continuously roll the short put day after day, collecting more and more premium- at least that is the plan. When the market moves, we have alternative plans to manage the positions, which are detailed in the other write-ups.
A couple of things bothered me about each trade. With 5 year expirations, interest rates play an outsized role in the performance of the long put, plus the trade ties up a lot of capital. At 60 days, having a long strike lower than the short caused some buying power issues when rolling strikes. In both cases, extended down moves greatly impacted the short put losses, while the long put didn’t provide that much protection. So, are there better choices out there?
As I researched the previous two articles, it struck me that higher Deltas would provide better long protection on the downside, and more short premium on the upside. I wanted to see if that played out in real life. I also realized that the shorter the duration of the long put in the trade, the less capital is tied up, making gains greater as a percentage of capital used. But it cuts both ways, the shorter duration long puts can’t provide the ballast of big capital and the day to day profit and losses as a percentage of capital are much bigger. So, is there a better setup to consider?
I turned to two sources to try and find some better answers- theoretical modelling and backtesting. For backtesting, I used the free service from TastyTrade.com. Their application only allows options with expirations up to 365 days and it can’t show results of trades closed in the past if the expiration is later than the time the backtest was done. But otherwise, I was able to get some meaningful data from trying different values in the tool. I also couldn’t put any complex rules for rolling just one side or managing rolls differently when the strikes get into the money, so I just set up to trade the same diagonal positions based on DTE and Deltas every day and close the trade after one day in trade. So, in effect, this backtest would similate rolling both sides of the trade back to center every day, a different approach than presented in the earlier articles, but similar enough that the data should directionally help point out better trade choices, if they exist.
Optimizing the 60 Day Long for Best Delta
In the write-up on the Daily Diagonal Covered Put, I used a 60 DTE long put and a 3 DTE short put, both at 40 Delta, which when I first started trading this strategy seemed high. When selling puts, typically Deltas in the 20-30 range seem to perform best, but in a diagonal situation, there just isn’t much room for error. Moving to 40 Delta helps by giving more bearish protection from long, and more premium on the short side to contribute in an up move. I put a backtest together for that trade, and it showed a 106% return on used capital for 2024, with a maximum drawdown of 34%. You can see it in the other page by following the link.
So, what if we kept going to 50 Delta on both the long and short options, keeping the same expirations? We get similar results:
60/3 DTE Diagonal with 50 Delta strikes Held for One Day- Entered every day
You can compare these side by side, but here are the takeaways from my point of view. The 50 Delta version requires a slight bit more capital. It also made more profit in dollars, but the percentage return total is slightly less. However, the 50 Delta version also looks a little less volatile, with a max drawdown of 30%. Interestingly, the biggest daily gain is bigger on the 50 Delta version, but the biggest daily loss is smaller- that’s two benefits I was looking for- better protection and more premium.
For reference, here is the setup of this trade, assuming the SPX index is trading at 6000:
I didn’t color in the profit and loss areas on this chart, but you can see that essentially after one day there is a profit if the index stays within the expected move. The backtest shows a 64% win rate, which looks to be right on what we would predict, as the profit curve isn’t completely covering the whole expected move. As a reminder, we expect to stay within the expected move 68% of the time. For more about Expected Moves, see the linked article.
It looks like our backtest profit per day is about 1/5 of the theoretical Theta value. If we can keep 20-25% of the Theta we have available, that’s a good trade.
Where is the maximum return?
Okay, it’s great that a little tweak can make some minor improvement to results, but let’s try other values. I spent a few hours entering different long and short duration values, and also playing around with different Delta values, and finally settled on 10 days for the long put and 2 days for the short put. Here’s the backtest results:
10/2 DTE Diagonal with 55 Delta strikes Held for One Day- Entered every day
This backtest really is impressive! Start with 195% Return on used capital, essentially 1% per day! This trade makes about the same dollar profit as the 60 DTE trade above, but uses half the capital. Additionally, the biggest one day gain is bigger in absolute dollars in this version than the 60 Day version and the biggest daily loss is much less, in fact in this trade the biggest daily loss is smaller than the biggest daily gain. The maximum drawdown on a percentage basis is slightly bigger, but much less on a dollar basis.
Let’s look at the setup of this trade on a theoretical basis, and see what kind of strikes we would be trading if the market were at a current price of 6000:
Notice again that the profit area of the chart is mostly inside the expected move, but not quite as much as the 60 Day version. And that plays out in the backtest where we have a 62% win rate. However, if we widen this chart, we see a big difference on downside risk:
Notice that the lowest one day loss flattens out to a little less than $2500, where other versions of this trade go down much further before they flatten out. With less duration in the long, the Delta of the long quickly catches up with the short as they approach 100, and there is the added benefit that the long is a higher strike than the short, so the very deep in the money value is less than the premium paid to get into the trade. So, even though we show the debit paid for the trade as the risk, the max loss is actually less on the down side. And if we look at the back test, we can see that the biggest daily loss was about $1400, which is less than this model predicts, probably due to different Implied Volatility at the point in the year when the loss occurred.
Before going further, you may be curious if I looked at even higher Deltas? Yes, I did and they started showing lower returns, probably because the increased capital required didn’t provide additional profit. What about 9 days, or 7? Or maybe 11? I looked at all the DTEs around 10 and 10 was best. I can only assume that maybe that has to do with 10 DTE being where IV tends to be minimized in the term structure, so premium has the best bang for the buck there? That’s only a guess, but it seems to be the best point in time according to the backtest. To be fair values a few days more or less or a few Deltas higher or lower weren’t that much different in the backtest results, but I found 10 DTE long, 2 DTE short, and 55 Delta optimized results.
Can we improve the 60 Day Diagonal?
After seeing that 2 DTE for the short worked better at our best spot along with 55 Delta, I went back to see what would happen with those changes with a 60 Day long put. Here’s the results:
60/3 DTE Diagonal with 50 Delta strikes Held for One Day- Entered every day
How about that! We improved our percentage return to 100% of used capital. We reduced our maximum drawdown. We raised our maximum daily profit more than we increase our biggest daily loss. We did need a little more capital. So, I’d call it marginal improvement over the earlier 60 day option.
Final Thoughts
One point to make sure everyone understands is that past performance in no guarantee of future results. Backtests show how something would have performed in the past. They also are completely mechanical and don’t take into account any human element of decision making, either good or bad. It also matters what timeframe the backtest was run, and 2024 was a mostly up year. However, I do think that they can point to help directionally compare different choices and show which kinds of trades have a tendency to do well and which don’t. Looking at values like biggest drawdown and largest daily loss starts to give you an idea of what the risk can be of a trade, and backtests with big upsides show possibilities for profits if conditions repeat.
I also studied different underlyings to see if similar results were possible, even if using weekly expirations. I’ll save that for another write-up in the future, but intial backtests look promising, matching what some of my option trading buddies have shared with their use of diagonals.
After working with the backtest and modelling different results, the conclusion is that our optimal setup appears to be much shorter duration long puts and much higher Delta values than what has been presented previously. Because my starting point was 5 year long puts, it took a while to realize that the better choice was much less convoluted and much easier to manage. Sometimes, it is easy to over complicate things. Here’s to keeping it more simple.
Feel free to leave a comment and share your experiences with this style of trade.
On August 5, 2024, the volatility index, VIX, spiked to 65, the fastest spike in Implied Volatility ever recorded. Anyone with significant holdings in naked options, including the 112, likely took significant losses.
The August 5, 2024 VIX Explosion Impact
In August 5, 2024 pre-market trading, the volatility index, VIX, spiked to 65, although the market was only down a moderate amount. The market had the fastest spike in Implied Volatility ever recorded, and anyone with significant holdings in naked options, and especially the 112, likely took significant, if not catastrophic losses.
Stock traders shrugged, but option traders, especially short in futures options, saw premiums explode to extreme levels. Short traders saw margin requirements explode and marked positions move to 10, 20, or even 30 times the initial amount collected in losses they couldn’t escape in illiquid markets.
The 112 trade, which is written about on this site in several places, was the poster child for big losses. Often traders use futures options that are leveraged to the max using SPAN margin. The trade promises to have a buffer of a 1-1 debit spread to provide a barrier from big losses in downturns. The 2 other short strikes are set to be so far out of the money that they should almost never get in the money for big losses. But this time it didn’t work- a fairly small downturn created huge losses and extreme increases in margin requirements.
Many seasoned traders I know saw their accounts reduced by 30-50% overnight with their brokers liquidating positions to satisfy margin requirements. In short, the debit side of this trade didn’t provide the promised protection during this event. Many traders, including me, saw big losses even though the debit spread didn’t even go in the money and the short puts were still well out of the money. It was the implied volatility that did the positions in, not the actual underlying market indexes.
Personal Impact
My experiences were mixed during this episode, but in all cases very eye-opening. I’ve done a lot of modelling of option pricing based on historical moves, the speed of moves, and other factors, and felt like I had a pretty good understanding of how volatility changes, even in big market moves. I survived the Covid crash, for goodness sake.
In most of my accounts, I had sufficient cash or cash equivalents to prevent a major problem with my account. However, I had one account that had two contracts of 112 positions that were using 90% of the account’s buying power before the big August 5 event (a bad idea in so many ways), and that account suffered a huge loss and was liquidated by my broker. I suffered a 250% loss, going from +$11,000 to -$17,000 overnight, which isn’t a small loss for anyone. My broker sold all of my short positions at the very bottom, in the early morning hours before the market even opened, locking in the losses, and then left the long spread positions to decrease in value as the market recovered, not allowing me to trade anything, due to having negative buying power in the account. It was a very helpless feeling to watch and see that much money evaporate. And then I got the email asking me to add money to get the account out of the hole. I asked why they had waited so long to close the positions, and why they didn’t wait any longer, but it isn’t the broker’s fault for this. It’s my problem and I have to own it. I simply got complacent and didn’t follow any of my own rules for capital allocation. I was greedy and I got burned- bad.
I wasn’t the only one, and in the aftermath, I read several option trader’s notes (that actually sell their trading advice) that lost years of profit during this event.
For all my other accounts that survived, the swings in value in accounts that had short options trading with margin was troubling and surprising. The fact that the values recovered as fast as they declined doesn’t change the fact that this could have been much worse and there are many lessons to learn.
For most stock investors, or even traders that sell option spreads or covered options, this event was no big deal. It was a problem for mainly for traders who sold naked options on margin, and especially for those that sold naked futures options on SPAN margin.
So, what actually happened, and why were so many option traders caught unprepared? Let’s dig into what happened, and then discuss how to avoid this kind of negative impact in the future.
The Perfect Storm of Fear
Markets were cruising to new highs in mid-July when it seemed that the market realized that maybe it was the time of year to finally step back and the market came down a bit. It was no big deal until August when the July jobs report came out on Friday August 2, showing very weak jobs data and an unexpected increase in unemployment. The market fell 1.8% during the day and there was a sense that the nation’s economy might be in trouble. Then over the weekend, foreign markets reacted, primarily in Japan, where the yen surged in value compared to the dollar, and many “safe” currency trades quickly unraveled. The Japenese stock market plunged over 12% in early trading, and the rest of the world followed along as other markets opened for Monday trading. With US Futures trading open, prices of all the indexes started down. Everyone trading wanted to get out, but there was no one available to bail them out. Futures options were the worst, with enormous bid-ask spreads with no one willing to make the market flow in orderly fashion. It was still the middle of the night.
Option traders awoke to alerts and margin calls from brokers. With an hour to go before the markets opened, buyers stepped in and started grabbing the bargain prices that were available, and selling short options for the astronomical prices that contracts were marked at, as brokers liquidated the unfortunate accounts of those who hadn’t cleared their negative balances. For those with cash, it was the opportunity of a lifetime. For those in trouble, some lost life savings over night. The best and worst of times.
When the market opened, it was down 3% from Friday’s close, but up from the worst levels of the night. It recovered about a percent in the morning but closed near where it opened. However, there was a sense that the worst had come and gone. Option prices quickly came back into somewhat normal ranges, and margin requirements relaxed. As the week progressed the market slowly eased up, day by day. By the end of the week, the market was essentially unchanged from the end of the previous week. Did anything really happen, or was it a dream? For almost everyone invested in the market, this situation was a non-event, a slight downturn, a bit of noise. But for Futures options traders that had naked positions, this was a never-to-forget nightmare.
By mid-August, it appeared that all the worries were for nothing. The US market moved back to near the record high levels set in July. Happy days were here again. But this isn’t normal.
Unprecedented Changes in Implied Volatility
In the past, increases in Implied Volatility have taken much bigger declines in the market for this big of a change. For example, during Covid, the market was down over 30% and the VIX volatility index hit 80 at the bottom after several weeks of large daily declines. The whole world’s economy came to a grinding halt and the market slid with it. At the time it was one of the most terrifying situations the world had seen.
In contrast, at the market’s lowest point on the morning of Monday, August 5, the S&P 500 futures were trading about 10% below the peak they hit in mid-July, and VIX sky-rocketed to 65. It was at less than 30 the Friday before. This rapid expansion in Implied Volatility over such a small timeframe and relatively small index price drop was unprecedented. Option prices multiplied in value and SPAN margin requirements for futures options increased exponentially. Brokers reached out in the middle of the night asking customers to add capital to their accounts, but from where, and how? Since the markets were closed, only minimal amounts of trading was going on and markets froze up with orders becoming unfillable. Trapped traders couldn’t get out, assuming they were even awake and aware of what was going on.
Likewise, the decrease in the VIX volatility index over the next few weeks was also remarkable. By August 16, the VIX index was below 15. Historically, large increases in volatility take months or even years to return to low levels, so this spike from levels of around 12 in early July to over 60 a month later, then back to 15 in less than two weeks is different than anything ever seen before.
For those not familiar, the VIX index is calculated by the CBOE to measure the volatility implied by options on the SPX index with expirations around 30 days away. The VIX index is not tradeable directly, but there are tradeable options, as well as futures that can be bought and sold. VIX is often considered the market’s “fear gauge,” but technically it is an evaluation of how richly options are priced. Since options are priced based on known values, with the only unknown value being volatility, this measure of “implied” volatility impacts all option prices. The numerical value of Implied Volatility of any option is a measure of how much the market expects the underlying security or index to move over the next year, but pro-rated down to the amount for the time left until option expiration.
Margin impacts
Margin works in a lot of ways with options. See the article on margin to learn more. But margin as true leverage is most apparent when selling naked options. For naked short options on stock, ETFs, or Indexes, most margin requirements are based roughly on having 20% of the notional value of the underlying in the account to cover a big move. So, one option contract on a stock trading at $100 would have a notional value of $10,000 and a seller of a naked option would be required to have $2000 for every contract, or would use $2000 of buying power or capital for each contract. If the stock moved 5%, the margin would likely require another 5% of the notional value, which could be as much or more than the premium collected.
If a trader is selling naked options on futures, a different margin calculation comes into play, SPAN margin. SPAN margin is a complex formula, but basically looks at the futures options positions and calculates a worst-case one day move, based on the IV of each option and other factors. This is typically a much lower requirement than what is required for options on stocks and ETFs, so a trader can have a lot more leverage. However, this works both ways. When the market moves, additional margin can be required based on the amount of the move, plus the amount that the “worst case” increased to. On August 5, when VIX spiked to over 60, the worst case scenarios as calculated by the SPAN margin calculation exploded by huge amounts, in addition to losses in holdings that were highly leveraged. As VIX virtually tripled, buying power requirements for futures options also went up by triple or more, when accounting for losses on top of the increased SPAN margin requirements.
Many traders in turn faced margin calls from brokers, asking them to get buying power from negative values to positive. For some the only way to do this was to buy back badly losing positions at big losses at terrible prices with terrible spreads. As much as anything, margin requirements drove liquidation as much as price movement.
The lesson on margin with options from this event is to always have cash or cash equivalent positions that can be easily liquidated to have cash to cover all margin requirements. Even a trader with the worst naked option exposure positions would be alright if their account was 80-90% cash. For me, I had accounts that I had to sell short term bond ETFs to cover buying power requirements on August 5. Every account but one was fine.
Within a few hours of the worst of August 5, VIX dropped significantly, and SPAN margin requirements reduced as well. The question was a matter of whether each trader had enough capital to weather the storm.
Marked loss impacts
When implied volatility spikes, Vega raises the price of options. On a percentage basis, the impact is greater for strikes further out of the money. For the 112 trade, the “1-1” portion of the trade that includes a 50 point wide debit spread has both strikes increase in price, fairly close to the same amount, while the two far out of the money strikes also rise substantially, but with nothing to cancel out their rise. The overall impact is that the total premium can grow much more than even the percentage increase in Implied Volatility. This is especially true if the positions were opened during a period of very low IV.
So, for a trader that opened a 112 trade when IV was down around 12-13 VIX, the explosion to a VIX of over 60 made the position’s premium value explode to 10-20 times what was collected, something that most traders would never have expected.
Position size considerations and notional value
With the 112 trade on /ES futures, a trader can use as little as $5000 buying power to control $500,000 of notional value. Even at very low Delta values for the 2 short strikes, it doesn’t take a very big move down to lose way more than the initial buying power. As we’ve just discussed, a big move causes two immediate problems for the trader, a marked loss as premium explodes, and an explosion of buying power requirements.
What is the solution? Keep trades like these a small portion of an account. The vast majority of the time, these trades just decay, leaving the seller with great profits, but when that rare occasion occurs, there needs to be plenty of capital in an account to cover losses and have the ability to manage the position.
Impact of the number of net naked options
I’ve tended to trade mostly covered positions and spreads, where this kind of scenario can’t happen because risk is defined, and a position can’t lose more than the buying power it requires. But it is easy to be persuaded by the siren call of those that tell traders to put on their big boy pants and sell naked options. Somehow, this is considered by some to be the mark of a mature option trader.
Often, traders are told that the buying power required is a good indicator of the risk of a trade. I’ve seen dozens of studies that make this claim. But typically, if you look at the fine print, these studies will say something like naked trades don’t lose more than their buying power 99.5% of the time, or some other high percentage. The problem is that the percentage is not 100%, and that little percent will surface on rare occasions, usually when least expected, immediately after a period of very calm markets.
The key isn’t to completely avoid naked trades, it is to manage the number of naked contracts being traded. During the August 5 event, 112 traders were much more impacted than 111 traders. The difference was two naked puts instead of one. Does that mean traders can load up on 111 and be fine? No, it just means that comparing two trades that both use naked options needs to account for the number of contracts that are naked and the difference in notional value and tail risk. Maybe the 112 trade has a slightly better return on capital typically than the 111. Is the additional risk worth it?
And it isn’t just the naked portion of multi-leg trades that need to be considered. Individual naked trades, as well as strangles or straddles sold naked can be even more susceptible to tail risk. There is a line of reasoning that diversifying will greatly reduce these risks, but in periods of uncertainty and big moves, prices fall across the board and implied volatility spikes everywhere.
Keeping the number of naked positions under control in an account may be the way to prevent a blow-up the next time the market melts down.
Defined risk vs. Naked Risk
If we compare risk of different types of option trading strategies, we can see that there is no risk-free way to trade options, and each risk level has a different set of risk parameters. Probably the closest comparison to selling naked options is to sell credit spreads.
Often, traders confuse the defined risk of credit spreads with being low-risk. In a credit spread, there is the very real risk of losing 100% of the buying power that was required or “defined” by the trade. However, during the August 5 event, the move didn’t impact most traders with out of the money put spreads, because both the long and short strikes of the trade went up significantly in value and if still out of the money, the net premium only went up a portion of the buying power as the moves mostly cancelled each other. Only when prices take an entire spread into the money are worst case scenarios in play. During the Covid crash where the market went down over 30%, this was the case for most spread traders. But on August 5, probably not.
Naked trades on the other hand have no hedge of a long option to provide any protection when the going gets tough. Naked traders are susceptible to both premium increase and buying power requirement increases at the same time when implied volatility spikes, even if the underlying price doesn’t move that far. This is the lesson for naked traders from August 5.
When the tide goes out, you find out who is swimming naked.
Warren Buffet has many famous quotes, and this is one of them. On August 5, 2024, if you were swimming naked with futures options in particular, or even naked options on margin in general, you were probably exposed. I’m not sure that this is exactly what Mr. Buffet meant by this saying, but in this case, a literal interpretation is very fitting.
One time event, or regular occurrence?
What happened on August 5, 2024 was a very unique set of circumstances that came together to create an unprecedented spike of implied volatility. Never before has VIX shot above 60 so quickly, and never before has VIX receded so quickly. So, is this rare event a once-in-a-lifetime occurrence, or will we see similar events on a regular basis?
I’m afraid that we are going to see this type of event many more times. We’ve seen global financial squeezes happen in the past, and this wasn’t even that crazy of a situation. The final straw that broke the proverbial camel’s back with this event was a liquidity crisis in Japan over a weekend. We’ve had other big banking fiascos around the world before and this one may not even be in the top 10 ugliest. What is different is the sheer amount of option positions that are in place now compared to only a few years ago. Today, it is normal for option volume to exceed the number of actual shares traded on major exchanges.
Why does the amount of option volume matter? While shareholders of stocks can simply hold through most downturns, option traders are often leveraged in fairly short duration positions that carry significant risk. When markets change, more traders need to purchase protection or need to get out of losing trades to stop their losses. If this happens when markets are closed, there isn’t much liquidity, and few sellers, so option prices go up, driving up implied volatility. With lots of people wanting to buy to get out or buy to protect, the lack of sellers can cause a panic. This is what we saw on the morning of August 5. Nothing has fundamentally changed since then, and option traders are continuing to grow in numbers.
My fear is that it will take less and less significant events to drive implied volatility and option prices to extreme levels going forward. So, if you weren’t impacted by VIX spike of August 5, consider this a warning shot across the bow. For some of us, they sunk our battleship. Don’t let it happen again.
The first half of 2024 was very good for the 112 strategy. Here’s an analysis of real trades, plus some choices if the market had crashed.
So far…
Occasionally, it’s good to look back and see how a strategy is performing. A lot of traders reach out with questions about the 112 strategy, so it seems like a good time to share some good news. When things are going well, it can be good to review details and see what insights can be gained. It’s also a time to consider what could go wrong in the future. For six months this trade has made money every single time I’ve traded it. That doesn’t happen often with any strategy, so it’s worth taking time to discuss.
I’ve been trading the 112 strategy for quite awhile. I’ve written about it here. That page goes through all the mechanics of the trade, so I won’t repeat that in this post. Instead, we’ll dig into some real world examples and talk about how I chose to manage the trade in a few different scenarios, and answer some questions that I’ve been asked in other forums about worst case scenarios.
A Brief Review of the 112 Strategy
While I won’t repeat the page on the 112 strategy, let’s do a brief overview of what this option strategy involves. Typically, I trade this using /ES futures options on the S&P 500, but I know lots of traders who trade it with other underlyings. I open the trade between 55 and 120 days before option expiration. The three digits of 1, 1, and 2 represent three different put option positions being traded in a ratio of 1:1:2. The 1-1 parts of the trade are buying a 50 point wide put debit spread that costs about $10 to open, and then selling 2 puts that are selling for about $10 each. The net result is that the opening of the trade is around $10 credit. How do I find the right strikes? Just do a little trial and error in the option table to find strikes 50 points apart that are $10 difference in premium. You’ll notice in my results that I actually try to collect slightly more than a net of $10, by picking a put debit spread that is slightly under $10 and selling puts with a premium of slightly more than $10. I usually end up somewhere between $11 and $13 net credit to start. Since I am trading /ES, there is a 50x multiplier, so the actual dollar credit to the account is $550 to $650 with that level of premium.
Most of the time, this is a slow boring trade that slowly decays. If the market goes up, I can usually close the trade for about 20% of what I paid and keep 70-80% of the premium I collected. Often, I only buy back the 2 far out of the money puts, and keep the 1:1 put debit spread in place as cheap insurance. I almost always close the 2 far out short puts early before expiration, usually between half and 2/3 of the way to expiration from when I entered.
Occasionally, the market drops and as long as the drop is not super quick, I can often close the trade for a credit. This happens when the 1:1 put debit spread goes into the money, but the 2 short far out puts have not increased that much. This can get a little nerve-wracking, but this is where big money comes in and why it makes sense to trade the 112 vs just selling one put for $10 out of the money.
On rare occasions, which hasn’t happened this year so far, the market will drop quickly, and 112 positions that are new and haven’t had time to decay will lose money. The 2 short puts will jump in value faster and more than the 1:1 put debit spread increases. If the 2 short puts were ever to get in the money, the losses really explode to catastrophic levels. A trader never wants that to happen. This is what people constantly ask about, and rightfully so- what can I do to prevent my account from blowing up in this situation?
The Results
Here’s a table of trades opened in 2024 that were closed by early July. It seemed like a good time to show this concept. There’s nothing special about the sheet- I just made columns for things I thought were important so I could look back later and see what I could learn. Others may track in different ways.
Most of the trades I chose were the 112 strategy, but you can see I sprinkled in a few 111s. The 111 trades were typically entered when the market was a little down and IV was up, giving me a little cushion on entry. You can also see that I varied the DTE entry, with many trades in the 50-65 DTE range to open, and others well over 100 DTE. Longer duration trades use less SPAN margin on futures and allow the far out puts with much lower strikes, but also a bit slower decay.
You can see that most trades were closed between 50 and 75% of the initial duration. In most cases, well over half the premium was kept. I’ve shown the initial premium collected and then the debit that was paid to close, or in several cases, there are negative numbers that mean I actually collected a credit to close, double-dipping with a credit to open and a credit to close.
From the data, you can see three different types of outcomes as mentioned earlier. When the market was on a sustained up move from opening, the trades were usually closed with about 70-80% of the initial credit kept. The trades could have been held to expiration, but closing them or just closing the far out put freed up capital to start new trades. Often, the put debit spread, the 1-1 of the 112 strategy was kept as insurance as there was usually very little value left in those two strikes.
When the market dipped in April, the opportunity came to close several 112 strategy positions for a credit. As price dropped to approach or even go below the upper strikes of the put debit spread, and the far out puts that had decayed already stayed at a low value, the net result was put debit spreads that were worth more than the 2 far out of the money puts combined. I generally watched the Delta values along with Theta to decide when to exit. I didn’t want to let the market get too close to my 2 far-out puts, and I also didn’t want the market to go up past my put debit spread before I closed the trade. You can see several trades that closed in that time frame with a credit, some close to the credit that was collected to start. One trade actually had a bigger credit to close than was received to open. I didn’t try to hold any of these trades to expiration and pin a maximum credit of $2500 per contract- the value of a $50 spread with the multiplier of 50 from /ES, it just never seemed like a position was going to settle there. In hindsight, I don’t think any of them would have- the market came back up not long after I closed the winning credit 112 positions.
There were two trades that are highlighted that were closed for less than 50% of the credit received. These were trades where the market dropped almost right away after the trade was entered. In these cases, when the put debit spread was breached, the 2 far-out puts were also gaining considerable premium. I decided to get out while the trade had a profit and not chance a further decline that could quickly explode to the downside. On one of these positions, I closed the put debit spread, and rolled out the 2 far-out puts to 151 days at a much lower strike, collecting $20 premium and buying a $10 put debit spread for an unconventional trade that closed three months later for a nice profit. So even the “bad” 112 strategy trades turned out okay.
What if…?
Clearly, it could have been worse, and the market could have fallen much faster, leading to big losses. I’m often asked, how can someone manage those kinds of really bad situations with this trade. I have three ways that are very different and each appeal to a different type of trading style.
Set a stop loss, either mentally or with your broker. Many traders I know will set a stop loss at 1x the maximum gain, which for 1 /ES contract of the 112 strategy is typically around $3000. Given that the average gain per contract was around $400, a trader needs at least 7-8 wins for every stop loss just to break even. But considering that it is possible to go a year or more without a loss, that isn’t bad odds. Just know that when the losses come, they are likely to come in numbers, so seller beware.
Define the risk by buying a protective put way below at the opening. This is the whole point of the 1122 and 1111 trades. Losses could be much larger than the stop loss tactic above, but losses are limited to the width between the double credit spread created way out of the money. Some traders add an additional put to make the strategy 1-1-2-3, with the idea that a very, very bad market drop could make the three cheap puts end up worth more than the two short puts- a reality if the market drops 30% within a few months. Besides still having a big maximum loss, adding long puts reduces Theta, so overall decay is slower. But for the once a decade event that crashes the market, this could save a disaster.
Get creative and roll the short put that is being tested way out and down for a credit. Bet that the market will turn around and give back all the losses that were taken. If possible, buy a new 50 wide put spread above the new strikes for $10, creating a new 112 strategy. This is the tactic I used on April 22. It worked out, but I wouldn’t recommend it. Most traders take their losses and move on, and consider this type of loss rolling irresponsible.
So there you have it. A variety of 112 strategy trades from the first half of 2024. Plus a reminder of things that might be done when the market has its eventual down move that is much worse than the little spring dip of this year. Happy trading everyone!
Follow-up note: As with many things, timing is important in trading. Within a few weeks of publishing this post, the market had the fastest spike in Implied Volatility ever recorded, and anyone with significant holdings in naked options, and especially the 112, likely took significant, if not catastrophic losses. In August 5, 2024 pre-market trading, VIX spiked to 65, although the market was only down a moderate amount. Stock traders shrugged, but option traders, especially short in futures options saw premiums explode to extreme levels. Short traders saw margin requirements explode and marked positions move to 10, 20, 0r even 30 times the initial amount collected in losses they couldn’t escape in illiquid markets.
Many seasoned traders I know saw their accounts reduced by 30-50% overnight with their brokers liquidating positions to satisfy margin requirements. In short, the debit side of this trade didn’t provide the promised protection during this event. Many traders, including me, saw big losses even though the debit spread didn’t even go in the money and the short puts were still well out of the money. It was the implied volatility that did the positions in, not the actual underlying market indexes.
I’ve written a separate longer analysis of this situation and the take-aways that all option traders should take from this. While this event was unprecedented, due to the amount of trading now done in options, I suspect that there will be similar, if not worse, events on occasion in the future.
1-1-2 put ratio option spreads are a very high probability trade. The 1-1-2 can be very profitable for sophisticated traders using margin. This trade has very high tail risk for extreme market moves.
I’m a big fan of front ratio type trades. I’ve written about my success with Broken Wing Butterflies and Broken Wing Put Condors. Taking this to a new level is the 1-1-2 Put Ratio trade. This is a new level of ratio trade, because it features naked options with a buffer of protection from a debit spread. The idea is a bit complex to grasp at first, and this is a trade only for traders that have a deep tolerance for risk. The trade involves buying one put and selling a total of 3 puts further out of the money to collect a net credit. Theta makes the value decay quickly, and over time, the purchased put can protect the short puts from most market moves.
I’ve written a separate post on the defined risk version of the 1-1-2 trade, the 1-1-2-2 Put Ratio, while the Broken Wing Put Condor, or 1-1-1-1 is a defined risk version of the 1-1-1, another ratio trade that is very similar. I don’t know of a named reference to a bird or insect for this trade, so I’m sticking with 1-1-2, although I’ve heard some liken the profit curve to that of a whale with a big profit hump and long tail.
I picked up the concept of this trade from one of my favorite traders, “Sweet Bobby” Gaines, who I have mentioned previously in at least one other page on this site. Bobby is a big proponent of the 1-1-2 trade, and has posted numerous videos on it on his YouTube channel, including his recent rising star appearance on Tasty Live. But really, these trades are the next level of evolution moving from broken wing butterfly to broken wing condor to “one louder” as they say in the mythical group Spinal Tap.
What all these trades have in common is selling an out of the money debit put spread, and financing by selling further out of the money puts. The combination delivers a net credit, but also sets up an interesting dynamic of extra rapid decay of the premium involved. The farther out puts decay faster than the closer debit spread, and often lead to the debit spread having more value than the farther out of the money put. This trade takes in a credit to open, and can possibly take in a credit to close. At least that’s how I set them up and manage them.
All these trades are a variation of a front ratio spread, where more options are sold than bought with hedges added to define risk. I’ve also written about back ratio spreads where more options are bought than sold. Front ratios are designed for maximizing decay, while back ratios set up multiple long positions paid for by a costly short position. So what is a 1-1-2?
1-1-2 Basic trade setup
The 1-1-2 takes this a step farther than the broken wing butterly or condor, because we use two puts very far out of the money to pay for the debit spread. The 1-1 part is buying a put around 25 delta and selling a put around 20 delta. The -2 part is selling two puts at around 5 delta. The goal is for the 2 puts to sell for about twice what the 1-1 debit spread cost. I like to set these up with 50-55 days remaining to expiration, quite a bit longer than the other ratio trades I’ve discussed. The added time allows the naked puts to be extremely far out of the money, while still having some meaningful value. I know other traders that go out even farther to over 100 days to get the strike price of the two very far out puts 25-40% below the current underlying price. Like all trades, it’s a matter of personal preference once you know the trade-offs.
What is the advantage of this setup? Well, because each of the two short strikes are further out, we greatly improve the odds of being profitable, and increase the initial rate of decay of the total position. We end up with a big gap between the debit spread strikes and the two short put strikes. Lots of good things happen with this setup. The biggest upside is that there is no upside risk- if price goes up, the trade makes money. The downside of this trade is that it can consume a lot of capital and has significant tail risk, which we will get into before we are done. Let’s look at a typical example.
The 1-1-2 trade has two naked puts sold short, but way out of the money.
While this table shows the risk as unlimited, it is actually $618,855, the value of two 3100 puts if SPX went to zero by expiration ($620,000) less the $1,145 collected to start the trade.
Some accounts and some brokers require all trades to be defined in their risk. For example, retirement accounts generally aren’t allowed to use option margin and so any naked put would have to be cash secured. That’s why I’ve written the note about the 1-1-2-2 trade which defines risk to just over $100,000 with two even further out of the money long calls (which is still a huge amount). For this 1-1-2 trade, eliminating those two long puts would mean the max loss would go up to $618,855, assuming that SPX went to zero, while we are holding two short 3100 puts. SPX will only go to zero if we see modern society end, and in that case, we’ll probably have bigger problems than our option positions. But rules are rules, and so if you want to trade without the long puts in a retirement account, you would need $620,000 capital to make a likely $800-$1200, or less than 0.2% return in 55 days or less, probably not the best use of capital. We’ll discuss other alternatives after we review the details of the 1-1-2 trade.
The profit profile for the 1-1-2 is very similar to the 1-1-2-2 other than the virtually unlimited loss.
This chart shows how changes in the underlying price will impact the profit and loss of the trade. We evaluate at four points in time. The green diamond shows our initial position at 55 DTE, underlying price is $4000, and the P/L is zero. The curvy lavender line shows how price would likely impact the position with 35 DTE. The green curve shows the likely profit at 14 DTE, and the sharp purple lines are the expiration values. We know exactly what expiration values will be at any price, but the curves are estimates based on likely impact to implied volatility as time passes and prices change.
The first thing I want to point out in this example is that the 3100 short put is 900 points below the current price of $4000. For that strike to get in the money, it would take a 22.5% decline in the market in 55 days. That won’t happen very often. To be fair, this example uses values with VIX at 25, a historically higher than average value, but for the timeframe of 2020-2022, a fairly middle of the road level. The higher that implied volatility is, the farther away the short strikes can be and still collect meaningful premium.
The next thing to point out in the setup numbers is the Greeks. Delta is fairly flat at +4.5. For a credit trade, that isn’t much and means that the position can handle some movement in price. Theta is $94/day, and we collected $1145. So, the position is expected to lose 1/12 of its value each day. But we have 55 days, so how does that work? Quite well, I’d say.
Remember that our starting underlying price is $4000 and the trade is profitable at expiration as long as price is above 3100. The chart above doesn’t show losses all the way down to zero price, but just imagine zero price and -$618,855. Our probability of profit is 96% if held to expiration based on the Delta of 4 for the naked puts.
1-1-2 Trade Expected Move Analysis
I’ve put in dotted lines to show the expected move and multiple expected moves down. If you need a refresher, check my earlier post on expected moves. It is likely that price will end up inside of one expected move, the dotted lines on either side of the current price of $4000. There is approximately a 2% chance that price will move two expected moves to the second dotted line below the current price, which would still be max profit for this trade at expiration. And there is approximately a 0.3% chance of moving three expected moves to the far left dotted line. We can go further, but the odds keep dropping as we go to lower levels. However, as history has shown, moves down tend to have somewhat higher probability than theoretical probabilities once we get beyond two expected moves. The point is that this trade is very likely to end up profitable, but there is risk that an extremely big move down could lead to an extremely big loss. We’ll talk about ways to reduce exposure later.
Let’s look at this another way. Prices don’t generally move immediately to a new level, but have probabilities of moves that get bigger over time. Again, going back to expected moves, let’s compare how we might expect price to move during the duration of the trade.
This chart shows expected moves day by day from initiating the trade until expiration, and compares to the put strike prices.
In this chart I’ve shown several outcomes. The zero move is if price doesn’t change at all, a baseline. I’ve shown a +1% move which is in line with the positive drift of the market. There’s also a line for the positive expected move and the negative expected move, where price is likely to be within at any point in time. And finally I’ve shown a curve for a price move of two times the expected move down. Notice where the strikes are relative to the price curves are. The negative curves take time to get below the upper 1-1 put debit spread strikes, and never reach even the short put of the 2 further out short puts. This chart also shows where two even further out long puts would be placed for a 1-1-2-2 version, but that’s covered in the post for that trade. For most people trading this strategy, defining risk with deep out of the money puts doesn’t provide a lot of protection as it is extremely unlikely that those puts would ever be in a position to reduce the level of a loss as this chart clearly shows. So, let’s not dwell on them.
Now let’s look at what happens to the value of our premium if price were to follow each of these curves. This is a view that you don’t see much because it is based on lots of assumptions for the pricing models. Since implied volatility is not predictable in the future, we have to guess how it will change if underlying prices change and how that will in turn impact prices. Based on how price changes have historically impacted implied volatility, we can have a decent estimate of how it will likely change with future price changes. I’ve used a model to take all that into consideration for these position value charts.
Most scenarios eventually show a profit with 1-1-2. Note that this chart shows position values, not profit. All values start with a value of -11.45 (the opening credit); the green shaded areas represent profit.
Looking at 1-1-2 values over time at the same price moves that we looked at for the expected move multiples, we can see that the premium changes are fairly dramatic and more positive as expiration approaches if the market is down.
Initially, this position collected $11.45 in premium, so we start with a negative or short value of -11.45. From there the price moves shown in the previous chart drive the premium up or down along with time decay. If price is flat or going up, premium decays and moves quickly toward zero premium. If the price goes down, the positive Delta pushes premium to more negative values. The price move of negative two expected moves really does a number on our premium initially, driving it down to below -40.
But, remember our profit chart at expiration? The flat and positive moves end up with a profit of our initial premium (all the puts have zero value at expiration, and the negative expected move and negative double expected move end up at maximum profit. Since our debit spread is 50 points wide, the negative moves would leave it fully in the money for a premium value of +50 points. And that’s in addition to the initial premium collected to open the trade. The challenge is that to get that max profit, we likely will have points in time where our position loses money.
The probability of getting to max profit is low because it would require a price drop between 6 and 22%. Based on our put strike Deltas we can estimate that we have about a 20% chance of that. Most of the other 80% is expiring with all strikes out of the money. So, it might be wise to zoom in and understand what happens with the vast majority of trades.
Zooming in on most likely outcome’s value over time
If we zoom in on the likely outcomes with the market being flat to up, we see that premium behaves very uniquely during the life of the trade.
If price goes up or drops less than 200 points, we can keep our initial premium at expiration. We may be able to collect more. The profit curve at 14 DTE is actually above the expiration profit if the price remains the same. How is this possible? Because the 1-1 debit put spread decays slower than the 2 naked low Delta puts, eventually the 1-1 part is worth more than the -2 part, even though the -2 part started out with twice the value of the 1-1.
I used this chart as the featured image of this post because I thought it best illustrates how this trade plays out most of the time. If you remember when we discussed the Greeks, I pointed out that Theta is very high compared to the premium. From this chart we see that if price stays the same or is slightly up, premium will decay to zero by 32 DTE, or just 23 days into the trade. This is an example that Theta isn’t 100% accurate by itself as it looked like 12 days of Theta should move us to zero value. From the chart you can see that the curve is fairly consistent for no underlying price movement as the value of the 1-1-2 position approaches zero, but still we have very rapid decay that I don’t think anyone can complain about.
Like all ratio style trades we have discussed, this trade has the possibility of switching from negative to positive premium. The difference with this trade is that it is actually quite likely, and as such we need to plan for it and manage our profit accordingly.
I’ve colored in the area under our three flat-to-positive curves with three zones each. There is a green zone where positive premium is growing, a yellow zone where premium is topping out, and a red zone where positive premium is being lost. Notice that the curve of the 1% up move and no price move are fairly close together, and that’s because the price movement is relatively close to the same compared to the other moves we are analyzing.
Let’s review how this happens. This trade essentially has two components, a slow decaying debit spread (1-1), and a fast decaying pair of deep out of the money naked puts (-2). The two naked puts decay faster because they are way farther out from the money, and have twice the value to start with than the debit spread. All these factors help decay happen more quickly. As long as the price stays fairly stable, this relationship will hold. Theta will be the primary driver of the premium value, and the low Delta naked puts will get to be worth less than the narrow debit spread.
The most likely scenario is that we stay inside the expected move and travel somewhere close to the no price move or 1% up move. Let’s realize that the market doesn’t move in equal amounts every day like this chart, so think of it as a smoothed out version of what premium would do. In the real world, premium would bounce up and down with price. However, if our price is close to where we started with 20 days until expiration, we would expect that the premium switch to positive has about maxed out, and it is probably a good time to close out the trade. Hopefully,your trading platform has a analysis feature that lets you look at your position and see how profits are changing day by day to help determine when the position is as high as it can go.
Without a chart, another way to determine how close the trade is to switching direction is to watch the position Theta. At the beginning of this trade, Theta was 0.942, or $94.16 for the full contract per day. As the trade progresses, Theta will decrease and at some point when the premium goes positive, Theta will turn from positive to negative. As it gets close to zero, that is the peak premium value. I generally try to exit the trade a few days before Theta is projected to turn negative. A big up day for the market could quickly change my very positive premium to not as positive premium, so it isn’t a time to get greedy.
So that brings us to the curve for the positive expected move. This is the curve that assumes that the price follows the one standard deviation move up. The good news when this happens is that premium decays very quickly because Delta and Theta team up. The not so good news is because the price move gets so far away from the strikes, the total position won’t get to a very high positive value. This is because all the options will drop in value quickly, approaching zero, and the upper debit spread won’t have much value. A big move up means that the probability of any of the strikes going into the money will be very low, so there is very little premium. As a result, it is likely we won’t be able to get out for much positive premium if any at all, but we will be able to keep most, if not all the premium from the opening trade. This is the least stressful outcome of the trade. If the price moves up faster than the expected move, premium will likely drop to very close to zero and may not ever go positive. So, if price is up a lot and the trade can be closed for a credit, I take the money and run. I’m happy to have a quick, winning trade.
As the trade progresses another helpful element is that Delta tends to reduce to zero or even become negative as time goes on if the underlying price stays close to flat. If a trader adds on many of these trades with different expirations, the overall position tends to be fairly low Delta and trades that have been in place for a while can buffer more recent positions. This is true until a really big move down hits and tests the naked puts. Then Delta grows quickly making losses pile up quickly as down moves continue.
The risky negative outcomes of the 1-1-2 trade
Looking at the position vs time value chart, there are two lines that represent what happens if price goes down. One is the move down one expected move and the other is down two expected moves. Interestingly, in this example, both end up at max profit by the end of the trade. So, it would appear that the trade can’t lose, which is far from true. Notice that these premium values may go very negative if prices drop quickly after opening the trade. This is because the narrow debit spread doesn’t pick up as much value from increasing delta as the wide credit spread does in a down move. We know that if price stays above our credit spread short strike at expiration, we will make money, but when price moves quickly down, it isn’t clear that price will level off.
So, as a trader, we are left with a choice when the market drops, We can take a loss and get out of the trade, or wait to see if the market quits dropping before it tests or violates the credit spread strikes. If we are a week or two into the trade, a decent down move will not make a huge impact, but initially the trade can take a big hit from a down move. The longer we are into the trade without a big down move in price, the less the risk is of a loss. On the flip side, a big move down opens the possibility of additional big down moves that can lead to a very big loss. We reviewed the odds earlier- about 4% of the time the trade will lose based on the far short puts having an initial Delta of 4. If this trade is done enough times, there will be some losses. Let’s look at some management actions that could be taken.
1. Set a stop based on premium price. In this example, we collected just over $11 premium to open the trade. So, we could set a stop to avoid losing twice ($22) or maybe even three times ($33) our initial premium. This would mean a stop loss if premium climbs to $33 or $44, given that $11 premium is our starting break-even point. This is the simplest risk mitigation strategy. Using this will lower the overall win rate as many negative scenarios would end up fine if not closed, but this management technique will prevent huge losses that might impact the account dramatically.
2. Close the trade if the underlying price goes below a trigger point. We know this trade has a lot of cushion. We can handle much more than one expected move and be profitable. But if the move is much more than expected, we have to consider that the move is very unusual and dangerous for us. Perhaps our point to get out is when the debit spread is in the money, or when we are half-way between the debit spread and two naked puts. Or maybe it is the strike of the short naked puts that is the final trigger to get out. The further down we allow price to go down, the more we stand to lose. Pick the underlying price where it gets too uncomfortable and use that as the trigger point to get out of the trade.
3. Roll out in time if premium or price triggers are hit. If the position is rolled, it can be rolled out for a credit. This gives more time for the market to turn around. However, it gives more time for a losing trader to lose more, because we likely can’t roll down much lower and still get a credit, and we will likely have to pay to roll the debit spread. If the price move continues down, there will be much less room to maneuver going forward.
4. Simply hold on and hope the probabilities play out. With 55 days in the trade, we just need to move down less that two expected moves by expiration. If the capital is available, and the conviction is there, holding can bring max profit with a big down move. Note that as time passes and the naked puts stay out of the money, the premium has to go away, so the value can evaporate very quickly with very high Theta as expiration approaches. This can be observed in the value vs time graph for the -2 EM curve. It can also result in a very large loss. As expiration approaches, the difference between max profit and a much bigger loss is just a few percentage points of price movement and the potential loss is much more than max profit.
In this example we can see that a move down of one expected move really doesn’t challenge our position, while two times the expected move is playing with fire. So, one approach might be to hold as long as the move stays within the expected move to the downside and switch to closing or rolling once the move exceeds that or some other multiple of expected moves. In any case, a trader has to know their risk tolerance and have a management plan for both winning and losing trades.
What about calls?
A logical question might be- if this works so great for puts, why not double up and do it for calls as well? Well, there’s one problem- skew. On indexes implied volatility is higher as strikes go to lower values and declines for higher strike prices. As a result, out of the money puts have higher implied volatility than out of the money calls. More importantly, far out of the money puts have higher implied volatility than puts closer to the money.
Look at our setup for this example. Implied volatility of the single long put is around 25, while the two short puts have implied volatility of 39. This helps two ways. The short puts have more of their premium tied to volatility, bumping up their price compared to the long put. Also, the higher implied volatility pushes the strike price further down to get a matching premium to the debit spread, making the trade a higher probability of success. We are selling more of the higher implied volatility and buying lower implied volatility, a key reason to use front ratio spreads.
A similar setup for a 1-1-2 call trade would reverse the dynamics. The long call closest to the money would have the highest implied volatility and the two short calls would have the lowest. To collect similar amounts to the put trade, the call strikes would be much closer between the debit spread and credit spread, and the difference in the deltas of the strikes would also be closer together, meaning a narrower window of max profit, and a higher probability of max loss. While still a trade with positive probability, it generally isn’t as attractive as the put side.
Buying power requirements for 1-1-2
I usually don’t spend much time talking about buying power because most trades I do are defined risk credit trades where the amount collected is a significant portion of the capital at risk. This trade is not so much, as it is a naked ratio spread (1-1-2). In non-margin accounts, we collect 0.2%, which isn’t much.
Below is an analysis of different possible ways to trade. I looked at trading each of these strategies three different ways. First, I looked at a cash secured account, like a retirement account. Next, I looked at an account with margin for naked options. Finally, I looked at a much different approach, trading futures options with span margin. The margin and span margin amounts came from entering this trade into the tastytrade trading platform. I’m also showing the defined risk 1-1-2-2 version for comparison as well.
Comparing buying power impact of different account types for the two strategies
I highlighted some key takeaway points. First, is how leveraged span margin with futures options can be for this trade. Our most capital efficient trade would be doing the 1-1-2-2 on futures span margin where we would collect 100 times the premium as a percentage of buying power (20%) than the non-margin account of the 1-1-2 trade (0.2%). Of course, with leverage comes much more risk. I chose to consider a loss of 10 times the initial credit as a practical worst-case scenario. The span margin would end up costing huge amounts more in a disaster and could potentially wipe out an account if the trade used a high percentage of the account’s capital. Span margin isn’t static, when a trade moves against a position, the span margin is re-calculated and the requirements can quickly explode in a big market move.
A couple of weird margin anomalies to point out. In my margin account, the defined risk 1-1-2-2 trade required almost twice the buying power as the undefined 1-1-2, which is weird because clearly there is more risk in the naked 1-1-2. I think it may be that the calculation for defined risk is normally much less than undefined and the software may just assume that margin is not useful in defined risk. On the other hand, defining the risk on the futures version cut the buying power by 1/3. Different brokers may calculate their margin requirements differently, so don’t take this as universal truth. Similarly, remember that while defining risk usually increases the return on capital, it makes outsize losses more likely, especially when scaling up. Notice that the highly leveraged futures 1-1-2-2 would lose twice as much as a percentage of capital that the futures 1-1-2 setup in a 10x loss. I discussed this phenomenon in detail in my post on comparing risk.
Remember that margin and span margin change as the trade progresses depending on the market behavior. Span margin is subject to big swings when prices go against a position. A broker may force a position to close much earlier than a trader would want to get out due to expanding capital requirements. So, while initially the position is cheap to enter, a trader needs to limit each position to a fraction of the overall account size.
But the good side of this is that this trade can be entered for a very small cost. The trade is very high probability. We can also make more than the premium collected. I didn’t include it in the chart, but maximum profit for the most leveraged choice above would be $5,805 profit on $4,000 buying power, a return on capital of 145%. And there is over a 20% probability of that happening.
One final note on the buying power analysis table. To keep the quantities an apples-to-apples comparison, I used double the number of /ES futures options because futures options only control half as much value as SPX index options. So, technically, those futures options trades listed are 2-2-4-4 and 2-2-4 because they use twice the number of contracts to get the same notional exposure. I reviewed differences between index options and futures options in detail in my post about different ways to trade options on the S&P 500 index.
What about small accounts?
Readers looking at this may be thinking, “Gee, this is great for multi-millionaires, but what if the account is too small to consider any of these buying powers?” Great question- there are other alternatives. First off, a trader could use half the buying power listed by just trading options on one contract of the Mini S&P 500 futures (/ES). The 1-1-2 example would only take $6,000 buying power for $572 premium received. But, if that is still too much, we can make it a lot less.
Many traders are more familiar with options on the SPY exchange traded fund, which trades at approximately 1/10 the value of the S&P 500 index. For futures options, there is also options on the Micro S&P 500 futures contract (/MES), equal to 1/10 of the /ES contract size, or 1/20 of the size of an SPX option. By using SPY or /MES, we cut the size of the trade down by 1/10 compared to the above table. If the account is taxable, another choice would be the $XSP index, a 1/10 value index of the S&P 500 with favorable tax treatment, but much lower liquidity with few options that far out in time. Again, all these alternative versions of S&P 500 options are discussed in my post on different S&P 500 choices.
So, for an account with futures trading capability, this trade could use /MES futures options and get into the 1-1-2 trade for just $600 buying power. An account with options margin could use SPY or $XSP and get into the 1-1-2 trade for $6,800 buying power. A trader doesn’t need a million dollar amount to trade this.
Concluding thoughts on 1-1-2 trades
I know a number of people who have traded versions of this trade during the bear market of 2022 without any issues. One trader I follow and interact with had one of their best years in 2022 because of this trade and the bear market that moved the market down, but not fast enough to ever drive the naked puts into the money. In fact, it could be argued that this trade, like most trades that collect credits from selling puts, works best if entering when the market is already down and implied volatility is high. Bad scenarios are already priced into option premium and there is a lot of cushion between strikes. This trade is most dangerous when volatility is low and prices are high- the probabilities are not as good, because a move of more than two times the expected move down is not nearly as far.
While not for everyone, the 1-1-2 trade provide a very high probability of success with a nice payout when used with leverage. The trade requires monitoring to maximize profit and to prevent catastrophic loss, so it really is not a set it and forget it trade. The key is to have a plan to manage the position if the market goes against the trade and stick to the plan.
Beginning option traders like to buy calls to start their option trading, and over time often learn the advantage of selling options and probability. But there’s a reason that long trades involving calls exist- the market goes up more than it goes down. We need strategies that use call trades to benefit from market moves up without experiencing huge amounts of time decay, or huge swings in positions. These 5 strategies provide some choices to get in on a bull market with calls.
(Without losing a lot of Theta decay)
Option buyers typically have low probability of profit because of the need to overcome Theta decay, the measure of how much option premium loses value every day. But often selling calls in a bull market is a loser as markets don’t offer much premium and go up more than expected. And the market is bullish 70-80% of the time. Are there call trades that take advantage and balance risk and opportunity better than others?
Each of these trades is built for a different type of trade mentality, so it is a personal choice based on risk, time frame, and how active a trader wants to be in the market. However, with the exception of the covered call, all leverage capital and risk a total loss of premium paid but with big potential gains.
When is a good time to do these kinds of trade? Selling options is best when IV is high. Buying options is best when Implied Volatility (IV) is low and option premium is cheap. When IV is high, big moves are anticipated, but even if the market goes up, IV can contract quickly and significantly counter the gains from an up move. One overall measure to watch is the VIX volatility index. VIX has a long-term average level of 18, and when it gets in the low teens, between 12-14, it doesn’t have much lower it can go. Individual stocks can be checked for their IV level by looking at IV rank or IV percentile. When VIX is low and a stock has an IV percentile or rank below 10, I’d consider the stock IV as low. This scenario happens frequently, especially in bull markets, which occur much more of the time than bear markets. On the flip side as the market goes up and IV goes down, selling options get less lucrative and more risky.
Let’s take the five strategies one at a time. There are also detailed write-ups of each on separate pages, so this is an introduction to these trades and to contrast the risks and benefits of each before digging in deep.
Covered Call Trades
Of the five trades listed above, the Covered Call is the most conservative and the only trade that is based on a net sale of options. The trade is a combination of owning 100 shares of stock and selling a call against the shares. Because the amount of capital at risk is essentially the value of the shares of stock, which are owned in the account, this trade has no leverage from options- instead it reduces leverage and risk by adding a hedge against the shares owned.
Let’s say a trader sells a call with a Delta of 30 against their shares. The net Delta of the Covered Call position becomes 70. This means the two part position acts like 70 shares instead of 100, making the position less volatile. Since the only option involved is one that was sold, time decay always works for the call seller.
Many traders love Covered Calls because it allows them to collect premium as a source of income on shares they already own, without taking on any additional risk. For many conservative option traders, this is the one and only option trade ever needed. Depending on the underlying and tactics used, it is possible to make 5-15% income on stocks in a portfolio. Because the trade involves selling options, the probability of profit is greater than 50%, the highest probability of the five trades listed.
Covered calls improve the probability of profit over owning stock alone in exchange for giving up unlimited upside.
So, what’s not to like? It depends on your perspective, but the Covered Call limits upside gains, but does only a little to reduce downside risk. If a Covered Call owner has stock that goes up a huge amount, the call will limit how much profit can be made. The trade will be a profit, but without the call, the profit could be more. By selling a call, the Covered Call trader is collecting premium in exchange for the possibility of missing out on a big up move. On the downside, collecting premium might be a small consolation if the stock drops dramatically.
For a conservative trader, the Covered Call is a way to reduce risk compared to simply owning stock outright. For an aggressive trader, the Covered Call uses a lot of capital to get a return potentially the same as the market, with no real downside protection. I’ve come full circle as a trader myself, going from a big fan, to dis-illusioned by the lack of upside, to recognizing the benefit of a less-volatile, positive probability trade.
Stock Replacement Call Trades
The next strategy is one that is often referred to as stock replacement. With this strategy, we can buy options that have the same upside as shares of stock but at a fraction of the cost. In theory any time someone buys a call, there is the same upside as stock, but some set-ups give a trader more of the upside benefit than others.
When I think of using options in place of stock, I’m looking for two things, relatively high probability and low Theta decay. When buying a option with no hedge, the natural way to lower time decay is to buy a call well out in time where it will decay slowly. To get it to move with the underlying stock, having an in-the-money option can get most of the move up (or down).
So for this strategy, I look for options 6-12 months out with a Delta value of 75-80. These options will likely cost 10-20% of the cost of the shares as they have significant intrinsic and extrinsic value. With over 6 months until expiration, time decay is slow, but still present.
In this example, a call is purchased with 84 days until expiration with a Delta of 0.78. Notice that even after several weeks, the profit curve is very close to that of owning stock around the money. Purchasing even longer duration options than this would provide less daily decay with even better downside protection.
Because I’m buying an option with a Delta of 75-80, I have the equivalent of 75-80 shares of stock from a price movement stand-point. If the price goes up, over time the Delta will increase and the option will behave closer and closer to the movement of 100 shares of stock.
The risk to the downside is limited to the amount paid for the options, so a big market drop could wipe out the position, but even a big drop would still likely hold some value, but mostly the extrinsic time value. However, the really good news is that losses in the options on a downturn are less than the losses that would come from 100 shares of stock.
My goal in this trade is not to hold until expiration, but to either exit or roll to a longer duration before we get into the last quarter before expiration. If the stock price has gone up, I can roll to a new time at a higher strike price and collect the amount the stock has appreciated less the time decay that was lost.
This trade needs a small move up to break even, so the theoretical probability of profit is a little less than 50%. But, by getting out way before expiration, the odds get ever closer to 50/50, and in a bull market the unlimited upside with limited downside is a pretty compelling proposition.
One watchout with this trade (and the others as well) is thinking that since we use just one fifth or one tenth of the capital of buying stock that we can now buy five or ten times as many options and really cash in. We have to respect the downside risk. A big move down will wipe out this position. So we don’t want to put all our eggs in this basket.
But when the market is frothy and looking like it is going nowhere but up, this is a good way to participate in the upside while protecting the downside, assuming that there’s plenty of capital left to deploy if the market suddenly goes against the position.
Poor Man’s Covered Call Trades
Covered calls have a number of trading advantages- they reduce volatility, provide some income, somewhat cushion a position from a fall. But, to have a covered call, you have to own stock first to sell a call against it. However, we just discussed the idea of using long calls as a substitute for stock, so if we sell a call against our stock equivalent we can have a low cost equivalent of a covered call, in other words a Poor Man’s Covered Call.
One difference is that our long calls have decay, and we want to counter that decay by selling calls with the same or more decay in our favor. A great way is to create a diagonal spread, selling calls that are closer to expiration while buying calls that are further away.
By selling a call with faster decay against our long call with slower decay, we can actually get a trade that has a greater than 50% probability of profit. The trade-off is that we limit the upside. The trade has defined risk and defined maximum profit.
My typical setup is to buy a 75 Delta call about 12 weeks out and sell a 25 Delta call about 6 weeks out, or half the time. If we look at a chart of each of the options profit potential along with how they compare to just owning stock, we get a bit of a complex chart:
In this chart we have two options with their own profit profiles at expiration. But, since they don’t expire at the same time, it is more important to see how they will perform at a certain point in time, like half-way to expiration for the shorter duration short call. After 21 days, the short call profit profile hugs the expiration profit profile much closer than the longer duration long call.
The key thing when looking at diagonal spread positions is that we really can’t think that much about expiration, especially for the long duration portion of the trade because it expires later. So, we really have to pay attention to how the projected values will behave at different points in time prior to expiration.
Another thing to notice is that the short call we sold has a strike price much closer to the current price than the long duration call. This means that there is more potential downside than upside, but that’s true with a regular covered call as well, actually even more so. At least our downside on this trade is limited.
When we put it all together in a chart, we can see how the trade profits not only when the market is up, but when the market is flat as well. Profitability with no underlying price change is due to the faster decay of the shorter duration short calls.
Notice the 21 days in trade profit line is profitable even in a slight down move.
Looking at the overall Delta of this trade, it opens with a net Delta of 50, or the equivalent movement of 50 shares of stock. So this position is half as volatile as owning 100 shares of stock for a cost equivalent to about 7.5% of owning 100 shares.
From a profit standpoint, our capital required was $750 and the maximum profit is $250. This shows how much upside we’ve given up by selling the call, compared to unlimited upside with the call alone. However, if we look at a “sweet spot” on the profit chart above, we can see that if price goes up from 100 to 102 in 21 days, the profit is around $150, a 20% return on capital for a 2% move. In comparison, a 2% price move on the earlier long call option only would yield about a 7% return on capital, and owning stock outright would net the owner, well, obviously 2%. one way or the other, I can roll out at the same time I’m repositioning the short leg.
Is there any magic to 84 and 42 days? Not really, it’s just a time frame that I find fairly manageable without a lot of stress, but with plenty of premium to collect on the short side of the trade. Longer durations have less stress, and shorter durations are more volatile with more potential profit. It’s a choice that depends on your trading preferences and risk tolerance.
There’s a lot of ways to manage the Poor Man’s Covered Call, and I’ve written about them in an extended post.
Buying an Out of the Money Call Spread
Buying an out of the money call spread seems counter to every theoretical calculation a person can do. The probability of expiring in the money is low by definition and time decay is the enemy big time. But, over the years I noticed that when I sold call spreads that were supposed to be profitable, either alone or as part of an Iron Condor, those spreads seemed to lose money often, and often lost a lot. One thing I’ve learned in trading is that if a strategy you use continually loses, try doing the opposite. So, here we are. I’ve done a lot of back-testing and trading my own positions to come up with a low probability strategy that actually wins over time.
As I tested different variations of this strategy, it became clear that the key was to keep the amount of capital required low with lots of upside potential, but high enough that the position has a chance for success. Also, this is a trade that works best when the trade is closed for a win and not held to expiration. It also does best with low implied volatility in a bull market.
There’s a lot more upside than downside for an out of the money call spread.
Buying a spread helps compared to buying a single out of the money call, because the sold call has similar Theta decay to the long call and counters the biggest reason for quick losses from buying calls.
With a little time and early management, this trade has a history of an actual positive average profit, even though the probability of profit from a single trade is well below 50%. Big wins can outpace a larger number of small losses. Read the detailed post about this strategy to find out the specifics to success with this trade that goes against virtually every concept I tend to advocate for.
The Call Back Ratio
In front ratio spreads, usually the goal is to sell more options than what is bought to have lots of decay protected a hedge of a long option. Front ratios are so much more common, that most people just call them ratio spreads and don’t even consider an opposite version, a back ratio.
A back ration spread involves buying more options than selling to take advantage of a big market move. With a call back ration, we may for example buy two calls and sell one call. If the market goes up, the two long calls will make more money than the short call will lose. The disadvantage is that Theta (time decay) can be a big problem. So, I have two variations of this trade that I use that somewhat counter this problem, but not completely.
A Delta neutral back ratio call spread is created by selling a call and buying two calls with exactly half the Delta of the call that was sold. The net Delta is zero, and the trade should net a credit- a trader is paid to enter the position. If both call strikes are out of the money, like when selling a 30 Delta call and buying two 15 Delta calls, it is very possible that the position will expire with everything out of the money and worthless, so the trader keeps the premium. If the market goes way up, the long calls will start to overcome the value of the short call with unlimited profit potential. Sounds great, doesn’t it? The downside is that the trade could end up with the short call in the money and the long calls out of the money worthless, so the trader is stuck with a loss quite a bit bigger than the credit received to start with.
A Delta-neutral call backspread makes money at expiration in a flat to down market or a big move up, but loses in a small move up.
An almost opposite variation flips the position of the long calls to make the trade a net debit and create the equivalent of 100 shares with zero extrinsic (time value). I picked up this concept on TastyLive.com. The Zero Extrinsic Back RAtio trade, or ZEBRA, buys two 75 Delta calls and sells one 50 Delta call for a net Delta of 100, or the equivalent of 100 shares of stock. The extrinsic value of these positions tend to cancel each other out, with twice as much time value in the short call as each of the long calls. So we get the movement of 100 shares of stock for a fraction of the cost and no extrinsic value for the position. In many ways this is a lot like the stock replacement discussed earlier.
The zero extrinsic value is a little deceptive in that the extrinsic value doesn’t decay equally. The extrinsic value of the two long calls decay faster than the extrinsic value of the short calls at the money. So, in the short term, Theta is negative, and we still need the market to move up to make money.
Beginning option traders like to buy calls to start their option trading, and over time often learn the advantage of selling options and probability. But there’s a reason that long trades involving calls exist- the market goes up more than it goes down. We need strategies that use call trades to benefit from market moves up without experiencing huge amounts of time decay, or huge swings in positions. These 5 strategies provide some choices to get in on a bull market with calls. Share your favorite bullish call trades in the comments.
Over the years I noticed that when I sold a call spread that was supposed to be profitable, those spreads seemed to lose money often, and often lost a lot. One thing I’ve learned in trading is that if a strategy you use continually loses, try doing the opposite.
Buying an out of the money spread seems counter to every theoretical calculation a person can do. The probability of expiring in the money is low by definition and time decay is our enemy big time. But, over the years I noticed that when I sold call spreads that were supposed to be profitable, either alone or as part of an Iron Condor, those spreads seemed to lose money often, and often lost a lot. One thing I’ve learned in trading is that if a strategy you use continually loses, try doing the opposite. So, here we are. I’ve done a lot of back-testing and trading my own positions to come up with a low probability strategy that actually wins over time.
Just to be clear, this trade can be named a lot of different things. Some may choose to call it a bullish or bull call spread because it benefits from prices going up. Others may call it a debit call spread because a trader pays a debit to get into it, versus a credit spread where the trader collects a credit. So, it’s a debit spread, a bull spread, and it means we are buying one call and selling a less expensive call.
As I tested different variations of this strategy, it became clear that the key was to keep the amount of capital required low with lots of upside potential, but high enough that the position has a chance for success. Also, this is a trade that works best when the trade is closed for a win and not held to expiration. It also does best with low Implied Volatility in a bull market.
In high Implied Volatility environments, options are expensive, and it is hard to justify buying them. A big move is needed to make up for the large amount of premium paid, and time decay eats away at the position.
In low Implied Volatility environments, the cost of options is low, and strikes with fairly low deltas are often inside the Expected Move. This is much more true for calls than puts, due to skew. So, for not much cost, we can get into a position that often out performs its probabilities. And with active management we can greatly improve the long-term profit and loss.
Why buy a call spread and not just buy a single call option, you might wonder? Two reasons, cost and time decay. Buy selling a lower probability call, I can significantly reduce how much I pay for the position, but see an even bigger decrease in Theta, the Greek variable measure for daily time decay.
A key relationship to know is that the Delta values of the two options in the spread give a relative calculation of the value of the spread. The average of the Delta values taken as a percentage represent roughly the percentage of the spread width that the premium is worth. A call spread of a 30 Delta call and a 20 Delta call will have a premium value of about 25% of the width of the spread. So, if the strikes are $2 apart, the premium will be approximately 50 cents. The percentage is usually a little closer to the Delta of the higher Delta strike due to skew, but as a rough estimate, the calculation works well. Why would we care? Because if we double our Delta values, we double the value of our premium in a spread. That will be a key theme for this particular trade.
Call Spread Set Up
Here is the set up of my preferred strikes for an out of the money call spread. I try to open this trade with somewhere around 6 weeks until expiration so that time decay isn’t too bad and I have plenty of time to manage the position. Like most option trades, I choose my strikes based on Delta values. For this trade I look for a call to buy that has a Delta value in the 20s, and a call to sell with a Delta in the teens. I want the difference in Deltas to be somewhere between 10 and 15.
Let’s look at an example of a stock or ETF currently trading at $100 per share. I find that the 103 and 105 strikes meet my criteria with 42 days until expiration. The Delta values are 29 and 16, a difference of 13. The premium is 54 cents, or 27% of the $2 width between the strike prices. We are closer to 29 than to 16 as a percentage value. Our short strike has 2/3 of the Theta decay as the long, despite being less than half the premium to start, a contrasting relationship to our advantage. The net Delta of 15 also represents that we have the equivalent of 15 shares of stock, but instead of paying $1500 for them, we only pay $54.
There’s a lot more upside than downside for an out of the money call spread. The key is to avoid expiration and limit time decay.
Looking at the profit chart, most analysis of this trade by others would focus on the expiration values, and note that at expiration we need the price to rise to around 103.54 to just break even. That’s true if the trade is held to expiration. But look at the colored curve lines that represent the value at different stock prices in a week or in three weeks. Those lines don’t need much of an increase in price to be profitable, and hold decent value in a small downturn as well. These curves are the secret to succeeding consistently with this trade.
The curved lines also bear out that Delta tells us how much we make or lose based on a dollar change in the underlying stock. We should make or lose about $15 for a dollar move in the stock price, and we can see from the 35 DTE curve that this is about what we’ll get.
Finally, notice that the colored curved lines of profit and loss don’t drop very far below the starting point of zero profit at $100 stock price. This is because there is only a small amount of Theta or time decay at the beginning of the trade compared to the days that come as expiration nears. Our goal will be to avoid the times when time decay kicks in.
We also would like to act based on the part of the curve that is better before expiration than at expiration. If we hold until our position is in the money, Theta switches and moves our profit toward the maximum at expiration. But the probabilities are that we won’t see these positions go into the money and Theta will be taking money from us in ever increasing amounts every day.
Managing the Out of the Money Call Spread
Like most option trades, I like to evaluate the trade with three possible management tactics, hold, fold, or roll. Holding to expiration lowers the probability of success, but might make sense if the market jumps up shortly after entering the trade. Folding or getting out early isn’t a bad strategy to lock in gains or limit losses with this trade by using limit orders. Rolling out regularly is best if the goal is to stay in the trade for the long haul. Let’s take these one at a time in more detail.
Holding a Call Spread to Expiration
Call Spreads are an interesting contradiction in the way Theta decay works. Theta either works for the trade or against the trade, and it can switch depending on whether the trade is in the money or out of the money. Theta is driving the value of the trade toward either zero or maximum value. When we own a Call Spread, Theta works against positions out of the money, but works for positions in the money. Since this particular version of the trade starts with strikes well out of the money, we need the underlying price to go up in a substantial way to make money.
The best time environment to trade this strategy is when IV is low and markets are rising. So, a nice move up can often happen. When it does and the position is in the money, the call premium will be less than maximum profit because the two call options have different levels of extrinsic (time) value left. We can hold the position until expiration to get the last bits of decay and get maximum profit. The risk is that the price can also reverse back out of the money and make the call spread decay toward zero value. For this reason, this is a trade that I don’t like to hold to expiration, I like to get out with a big profit, either with a profitable limit order, or rolling to a longer duration while taking profit.
If the market goes down instead of up, I think it makes even less sense to hold, because the probabilities will have gone down for profit, and the remaining premium will decay even faster. A turnaround to get into the money is needed and there probably isn’t enough time. So, I’d again fold or roll.
Folding with Limits
Many traders like to use limit orders to cash out wins, or limit losses. For traders that are inclined to use limits, this call spread trade set-up has some natural places to get out. Since the upside is higher than the downside, but the probabilities are that the trade loses more often than wins, we need to make sure that wins are much bigger than the losses. One easy natural limit is to take a win when the position doubles in value, or fold for a loss when the position is cut in half. Doing this means we need win better than one out of three trades to make a profit over time on the trades that close on a limit. Let’s look at each scenario, plus the scenario of hitting neither limit.
This trade starts with a long call that has somewhere around a 25% probability of expiring in the money. But it also has about a 50% chance of a touch- the price reaches the strike price sometime before expiration. Depending on exactly which strikes we started with in our call spread, our initial premium is likely 20-25% of the width of the spread, as we discussed earlier, based on the Delta of our two strikes. That means we need the width of the spread to move up to 40-50% of the width of the spread to double in value. Getting our long strike to go in the money, even briefly, should do the trick. Are you with me on the logic and statistics here? Based on all these assumptions, we have somewhere around a 50% chance to double our money on this trade at some point before expiration. But we don’t have a 50% chance to expire in the money. So, if and when it happens, the logical thing to do would be to take the money and run.
Wait, isn’t there some old trading rule that you are supposed to let your winners run and stop your losses? If we close for doubling our money, we give up the chance to get triple or hit max profit. Yes, but with options, time is limited. Markets go up and down, and nobody knows what will happen next. When we get a big win, it makes sense to take profit before it evaporates, and then don’t look back. Usually by the time we hit double our initial premium, a lot of time has passed and there isn’t that much time left in the option, and the probability of making more is still no better than 50/50. We started with a low probability trade, and have a shot to double our money 50% of the time, let’s take that.
A couple of additional factors to consider. Theta decay increases as the trade goes on, so if we can get out early before Theta has a big impact, the big decay at the end can be avoided. Second, one assumption going into the trade in a low Implied Volatility environment is that we are in a bull market, which actually helps our chances of a win.
What about limiting the loss? If we enter a stop limit at half the premium collected, are we giving up too early? Looking at our initial Deltas and how that relates to the width of the spread, our call spread will lose half its value if our Deltas drop in half. Whether that happens due to a downturn or due to time passing, the probabilities of a winning trade or especially doubling the initial value of the trade decline significantly, and the probability of the trade expiring worthless if left alone will have increased significantly. So, the idea is to cut our losses and save some of our capital for another day. Additionally, Theta decay is only going to increase and quickly doom the trade to zero if we don’t exit.
If we enter this stop loss limit order, how often will it execute? Somewhere close to 50% of the time, maybe a little more. But we can’t have a profit limit order executing 50% of the time, and a stop loss limit order executing over 50% of the time. That would be over 100% of the time, and we haven’t even talked about a third possibility. The issue is that if we use a stop limit, some of the occurrences that we are stopped out on are situations where we would have doubled our money if we hadn’t been stopped out. So we actually reduce our odds of doubling to less than 50% with a stop loss, but not a whole lot, because to go from a 50% loss to a 100% gain would take a 4x gain from that low point, a low probability, but not zero.
Let’s look at the math. If our long call Delta falls to the 12-15 range, our chance of that strike being touched would then be 25-30%. But if that situation happened in 50% of our total occurrences, we would be giving up 12-15% of our occurrences that are destined to win, so now our doubles are 35-38% of all occurances.
There’s a third possibility with our fold strategy. We could have neither limit order execute and the trade expire somewhere between losing half and doubling. This is a fairly low probability with the two limit orders in place, because as expiration nears, the trade gets more likely to move toward max loss or max gain. To expire between the long call needs to expire in the money and the short call out of the money. And the position would have to have crept into that position and been very stable especially in the last few days to not trigger either limit order. The probability of this happening are difficult to calculate, but will be well under 10%, maybe less than 5%.
If the trade gets close to expiration and hasn’t triggered a limit, it might be a good time to consider closing early to reduce drama and hopefully collect a profit on the trade. But again, that will change the overall probabilities slightly.
With the bull market on our side, let’s assume we can double our initial premium 40% of the time, stop loss limit out 55% of the time for a 50% loss, and hold on somewhere between to expiration 5% of the time. If these probabilities held up over time, we’d average a 13% gain on this trade.
For these probabilities to play out in actual results, a trader would need to trade the same amount in dollars or in number of contracts each trade. So, set aside the winning amounts to use for making up for losing trades. It’s likely that there would be many winning trades in a row, and many losing trades in a row. Having a variable amount of cash to both compensate for losses and bank winnings would be critical.
Alternatively, letting the size of the trade double or be cut in half based on the result of each previous trade wouldn’t work. Since there are more losses than winners, the account would get cut in half more often than it doubled, and eventually be cut to essentially no value.
Thinking about this way of managing the trade over time and the implications of huge wins and huge losses, this management tactic seems pretty extreme. It provides very extreme volatility, even if a trader consistently trades the same amount of capital trade after trade. As such, this would only make sense as a very small portion of a portfolio.
Continually rolling a credit spread
If you’ve read very many other trading strategies I’ve written about, you’ll know I generally like the concept of rolling my option trades. Rolling is the concept of closing an existing trade and opening a similar trade at a later expiration and/or different strike prices. In most platforms, this can be done in a single simultaneous transaction, so that the net result is clear- is the trade collecting a credit, or paying a debit to re-position?
With a debit call spread (a spread that we are buying), we can still collect a credit to roll from one position to another. This is because we can sell a call spread that has increased in value to buy a cheaper spread that is further out of the money. If we roll to new positions over and over, and the total of our credits are more than the total of our debits, this is a winning management tactic. Both back-testing and my experience show that this tactic works for this trade most of the time, particularly in bull markets.
I like to set up a trade like we’ve used as an example earlier in this post with 42 days to expiration, and then roll after a week. After a week, time decay is relatively small, and a price move up in the underlying of a percent or two makes more than a price move down of a percent or two loses on the trade. The longer the position sits, the more time decay moves the profit curve down, requiring a bigger up move to be profitable. If the market chops up and down, the trade can eke out a profit over time. The reason is that there is much more upside than downside because of the strikes that were chosen to start the trade. But, because the underlying market is bullish, the wins should be more frequent than losers, which really makes this strategy work over time.
Let’s take an example. We buy the call spread in our example for $54 with 42 DTE. After a week the stock is up 2% and our position is worth $80, a $26 gain. We roll this trade by selling our now 35 DTE call spread for $80, and buying a new 42 DTE call spread for $54 again, but now at $2 higher strikes than the week before to have essentially the same Deltas as the position we started with a week earlier. We collect a credit of $26.
A week later, the stock goes down 1% and our call spread is worth $34, a loss of $20. We roll out to 42 DTE again, and this time pay $20 to buy more expensive strikes at $1 lower prices. Now, we have a total of $6 collected from our two rolls.
The next week, the stock jumps 3.5% and our call spread is now worth $110. We roll our position out again to 42 DTE and buy higher strikes for $54, a net credit of $56. Now, we have $62 collected.
The next week, stock drops back 4.5% to our starting price of 100 and our call spread is only worth $3. Ouch- a $51 loss! But, we roll back to 42 DTE and our original strikes paying $54, paying a $51 debit.
After 4 weeks with a stock going up and down and ending in the same place, we have collected $11 total on a $54 use of capital. That’s a 20% return on capital on a stock that didn’t move.
But, we haven’t accounted for broker commissions. At 50 cents a contract, that’s $2 each week, or $8 for 4 weeks, most of our profit. So, we might want to look for stock that has a little higher price where the commission is less of a percentage of the likely profit.
We also expect the market to trend up in a bull market, so that winning weeks outnumber losing weeks.
The advantage of rolling and staying well away from expiration is that we avoid the rapid decay near expiration and we achieve much of the same result as the previous “folding” limit management tactic with constant trade size, but in a more disciplined drum-beat approach. We aren’t tempted to bump up our trade size or cut it way down, because we are just rolling the same number of contracts out week after week, adding or subtracting cash as we go.
From a practical standpoint, each week we have to evaluate what the right strikes to choose are. I try to maintain the same width, but then look for Delta values that meet my criteria. The higher the strike prices, the further out of the money the strikes are, and the lower the cost and the lower the Deltas. I can maneuver around a little to make my new position cheaper than the one I’m closing and collect a credit.
Also, if we have a big move in less than a week, I may choose to roll up my strikes in the same expiration to bank my profit and limit the downside in case of a reversal. In our example, if the stock price went up $4 in a couple of days, I’d roll up my strikes $4 and collect $65 to get my Deltas back to the starting range.
Why this Delta range works
Delta is a very handy measure for options. And for this call spread trade, its many uses really illustrate how this trade works. For call spread, we can take the combination of the Delta value of the two call options to get a net Delta value. In this example, with Deltas of 29 and -16, the net Delta is 13. (Call Deltas are positive. Owning a call is positive Delta, being short is negative Delta.)
If we look at Delta’s definition as a relation of change in price of the stock to change in price of the call spread, we can see that if the stock goes up $1 in price, our call spread premium goes up 13 cents, or $13 for the full contract. As a representation of equivalent stock, 13 Delta means we have the equivalent of 13 shares of stock.
Now, we could have this same price movement and share equivalent with any number of call strike price combinations. We could have bought a 50 Delta and sold a 37 Delta, or bought a 93 Delta and sold an 80 Delta and had the same behavior. 13 Delta is 13 Delta. So, what is the difference?
Remember, Delta is also a measure of probability and value of a spread. Both of these are tied to the individual Deltas more than the net Delta. Probability informs us of what is likely to happen to each option if held to expiration, or how likely it is that the stock price will touch the strike price before expiration. These probabilities inform our management of the option, as we’ve discussed earlier in this write-up. If we chose different strikes, we’d probably want to consider management tactics differently to optimize the trade.
But the real key is the relationship of Delta as a measurement of the value of the spread. Earlier, we mentioned that the average Delta of the two options in a spread roughly approximates the premium when calculated as a percentage of the width of the spread. Sounds complicated, but not really. In our example, our strikes are 103 and 105- the width of the spread is 2. The average of our Deltas is 23.5, so we should expect premium to be around 47 cents (23.5% of $2)- it’s actually 54 cents, but close enough for a rough estimate.
The value of our call spread can vary anywhere from 0 to $2 by expiration, so there is a lot further to go up than to go down. Picking lower delta strikes limits our downside, but gives us lots of upside. That plays out over time with this trade, as long as we don’t plan on holding on too long.
If we chose strikes deep in the money, we’d be virtually guaranteed to expire in the money, but our profit potential would be very limited, while our potential loss would be high. I think there are better ways to use deep in the money calls like a stock substitution strategy using calls, or a poor man’s covered call.
At the beginning of this writing, I mentioned how initially I used to sell call spreads, but realized I was consistently losing money. I looked at a lot of different ways to trade the opposite, to buy call spreads instead of selling. One tool I use for analysis is back-testing. As commercials like to say, “past results is no guarantee of future earnings,” but with big samples back-tests can provide a clue as to what works more often than not. I back-tested a wide variety of call spread values at different Deltas, different expirations, different management strategies, and different market environments before settling on this variation. I’ve traded it a lot myself with good results.
The example I’ve used in this writing is a little closer to the money than I’d ideally prefer. A little further out of the money would get the premium more around 20% of the width, which would cost less to start. The net Delta is fine, but if there were more choices, I might make is slightly less. Wider spreads are good for selling spreads, narrower is better for buying spreads, due to Theta differences.
Can we get too far out of the money, or too narrow? Yes, at some point the premium we pay and the potential profits get too small compared to the commissions and fees required. So, small spreads on cheap stocks may not make enough to pay for trading costs. And for those that might get options trades for free or close to free, there is still the cost of bad fills if an option is not extremely liquid.
This isn’t to say that other variations won’t work. There are pros and cons to every element of this trade. The differences in returns and risk can be adjusted many different ways. I’ve tried to illustrate the trade-offs so each trader can make their own informed choice.
Assignment Risk
One factor we haven’t discussed yet for buying call spreads that can’t be ignored is the risk of having a short call exercised while still holding the long call. As with other strategies that have an element of selling calls, there are some call assignments that can be avoided and some that can’t.
There are three situations that greatly increase the chance of a short call being exercised by the buyer. They are having a call in the money, having a call near expiration, and being short a call when a stock goes ex-dividend. The good news is that the way I execute this trade, these factors should rarely come into play.
First off, the short call is much less likely to end up in the money than the long call. If we start by selling a call with less than 20 Delta, it has less than a 40% chance of having the stock even touch its strike price.
My plan is never to hold until expiration, so that part of the assignment risk is mostly avoided. For those who hold in the money spreads near expiration to try and get max profit, this is a double dare to the buyer of the trader’s short call to exercise early. So, someone who holds a winning trade until expiration shouldn’t be surprised to wake up short 100 shares of stock instead of being short a call option.
Dividend risk is probably the hardest call exercise to avoid, but the key is to have a short call with more extrinsic or time value than the anticipated dividend, and have strikes further out of the money than the dividend. If a trader can do that, there is no reason for a call owner to execute from the other side of the trade. The easiest way to keep a high extrinsic value lines up with the other tactics- get out of positions close to the money and keep expiration away by closing or rolling anything with short duration.
As I’ve explained in other write-ups, having a short option assigned/exercised isn’t that big of a deal to undo, especially when it is part of a spread. A trader may wake up and find a large amount of short stock and a large amount of cash that wasn’t in the account the day before, but that’s what happens when shares that you don’t have get called away. In this case, the intrinsic/in-the-money portion of the long call will always be worth more than the intrinsic value of the short call, so the long call can be sold and the short shares that were assigned can be bought back, all in one transaction, for a tidy overall profit.
Final Thoughts
Buying a call spread like the trade discussed here should not be the core of a portfolio- the trade is simply too volatile for anything other than a way to supplement returns in appropriate market conditions. But, as used as a part of broader portfolio of trades, it can be a way to take advantage of a bullish market with low Implied Volatility. Buying calls out of the money doesn’t have to include a lot of decay. Using a spread reduces the time decay and makes what would seem like a losing trade show profits over the long haul.
if we sell a call against our stock equivalent we can have a low cost equivalent of a covered call, in other words a Poor Man’s Covered Call. One difference is that our long calls have decay, and we want to counter that decay by selling calls with the same or more decay in our favor. A great way is to create a diagonal spread, selling calls that are closer to expiration while buying calls that are further away.
Covered calls have a number of trading advantages- they reduce volatility, provide some income, somewhat cushion a position from a fall. But, to have a covered call, you have to own stock first to sell a call against it. However, we have discussed the idea of using long calls as a substitute for stock, so if we sell a call against our stock equivalent we can have a low cost equivalent of a covered call, in other words a Poor Man’s Covered Call.
One difference is that our long calls have decay, and we want to counter that decay by selling calls with the same or more decay in our favor. A great way is to create a diagonal spread, selling calls that are closer to expiration while buying calls that are further away.
By selling a call with faster decay against our long call with slower decay, we can actually get a trade that has a greater than 50% probability of profit. The trade-off is that we limit the upside. The trade has defined risk and defined maximum profit.
My typical setup is to buy a 75 Delta call about 12 weeks out and sell a 25 Delta call about 6 weeks out, or half the time. If we look at a chart of each of the options profit potential along with how they compare to just owning stock, we get a bit of a complex chart:
In this chart we have two options with their own profit profiles at expiration. But, since they don’t expire at the same time, it is more important to see how they will perform at a certain point in time, like half-way to expiration for the shorter duration short call. After 21 days, the short call profit profile hugs the expiration profit profile much closer than the longer duration long call.
The key thing when looking at diagonal spread positions is that we really can’t think that much about expiration, especially for the long duration portion of the trade because it expires later. So, we really have to pay attention to how the projected values will behave at different points in time prior to expiration.
Another thing to notice is that the short call we sold has a strike price much closer to the current price than the long duration call. This means that there is more potential downside than upside, but that’s true with a regular covered call as well, actually even more so. At least our downside on this trade is limited.
When we put it all together in a chart, we can see how the trade profits not only when the market is up, but when the market is flat as well. Profitability with no underlying price change is due to the faster decay of the shorter duration short calls.
Notice the 21 days in trade profit line is profitable even in a slight down move.
Looking at the overall Delta of this trade, it opens with a net Delta of 50, or the equivalent movement of 50 shares of stock. So this position is half as volatile as owning 100 shares of stock for a cost equivalent to about 7.5% of owning 100 shares.
From a profit standpoint, our capital required was $750 and the maximum profit is $250. This shows how much upside we’ve given up by selling the call, compared to unlimited upside with the call alone. However, if we look at a “sweet spot” on the profit chart above, we can see that if price goes up from 100 to 102 in 21 days, the profit is around $150, a 20% return on capital for a 2% move. In comparison, a 2% price move on the earlier long call option only would yield about a 7% return on capital, and owning stock outright would net the owner, well, obviously 2%.
Managing the Poor Man’s Covered Call
How do we manage a Poor Man’s Covered Call? Generally, there are three ways to manage positions like this: hold, fold, or roll. Let’s take them one by one.
Hold means we just hold until expiration. But, remember these options expire at different times, so we could hold until the short leg expires and close the long. We’ll get good Theta decay and not really need to pay much attention. Probability of profit is over 50%, so it’s a viable strategy. However, if we let both options expire independently, we can see from the expiration profit chart that we need an increase in price to be profitable, so we do need to get out of the long call before expiration, preferably when we exit the short call.
Folding or getting out with an early exit isn’t a bad choice either. We can set a profit target, say half the maximum profit and set a limit order and also have an equal stop loss or slightly larger stop loss, and let the trade play out. Probability is over 50%, so hopefully we catch a modest up move and miss any big down move, collect a nice profit, and move on. As a short term strategy, this can be a good approach, especially if we were to set up a ladder of ongoing versions of this every few weeks and just let each one play out individually.
If you’ve read much of the other parts of this site, you know that I tend to favor rolling strategies, often continuous rolls. I like to roll positions out in time, over and over, adjusting them up or down with the market. Generally, the plan for this trade is to actively manage the short duration leg more than the long duration leg, but keep the long duration out in time and the short duration around half the time as the long, give or take a bit.
Here’s an example of rolling a position that starts with a short call at 42 days and a long call at 84 days. Typically, the short leg will get rolled more often, since it is decaying faster and is more prone to changes in Delta value and its premium.
In the chart above, I’m illustrating the concept. The idea is that every two to three weeks the short leg gets rolled out in time. Well, which one is it, you might ask, two or three? I would look at it based on criteria, if the short has gotten way out of the money, say below a 12 Delta in two weeks, I’d roll out and establish a new 42 day position and collect a net credit. Or, if the short strike is being tested and has moved to a Delta of 40 or more, I’d roll out and try to reduce Delta and collect a credit in the process- it’s easier to roll a single short leg for a credit than to roll a spread, so I should be able to improve my position in the process. If however, the price keeps Delta between 12 and 40, let’s just keep collecting Theta and wait until 21 days left to roll. At that point, we roll out to 42 days again and pick a nice strike and get a nice credit for our effort.
For the long call, I mostly just leave it alone. I let it do its thing until it gets down around 42 days and kick it back out to 84 days. If the market is up, I can move the strikes up to 75 Delta and get a credit. If the market is down, I’ll have to pay to roll out. If there is a really big move one way or the other, I can roll out at the same time I’m repositioning the short leg.
Managing Big Moves
So, we can set up rules to guide our rolls and generally just let the data from the market dictate our actions. The only other thing to consider is what to do if the price jumps way outside our strikes? With individual stocks, this is a clear possibility, so there needs to be a plan. On a huge jump up, the choices are to close for a max profit and move on figuring that all the good news is priced in, or reset with a roll to new strikes in anticipation of further up moves. On a huge down move, we can close out both sides for whatever premium is left on the long call if it looks like the bottom has fallen out for good, or just hang on to the long call and hope for a reversal, maybe selling a new call at the same price to cushion the blow. There’s no right answer, just the right answer for each trader’s personal tolerance for risk. But, every trader needs a plan. The one strategy that many traders take by default is to cash in small gains and hang on to big losers, which pretty much guarantees a losing portfolio over time.
Overall considerations
Is there any magic to 84 and 42 days? Not really, it’s just a time frame that I find fairly manageable without a lot of stress, but with plenty of premium to collect on the short side of the trade. Longer durations have less stress, and shorter durations are more volatile with more potential profit. It’s a choice that depends on your trading preferences and risk tolerance. Many traders of this strategy like to go to much longer durations with their long strike, to six months or even a year, to keep Theta less, but the trade-off is that the cost and downside risk is more.
Similarly, is there magic to 75 and 25 Delta? Not magic, but the goal is to have more decay in the short strike than the long, so equally distant Deltas at different expirations should achieve that. Many traders will buy call strikes deeper in the money to make this advantage greater, with the trade-off of a higher premium cost and having more more capital.
Between time to expiration and the Deltas chosen, we can significantly adjust Theta of our long strike. We can also greatly control the amount of capital required for the long call, from around 5% of the cost of stock to 20%. Understand that this is the trade-off, capital cost and downside risk vs. decay. The ultimate extreme is going back to a covered call, where we own stock instead of a call. Buying a call instead saves capital, and also limits the loss. So, in choosing the long side of the strategy, consider the choice of time and Delta as part of a continuum of risk and reward.
Trade Sizing: Leverage and Risk
Finally, remember that just because a poor man’s covered call has less capital required than a standard covered call, it doesn’t mean that it is a good idea to do 10 poor man’s covered call positions instead of a single covered call. Just because a trade is affordable, it doesn’t mean it is a good idea to bet the farm on it. The poor man’s covered call is a trade of leverage. It can be a trade to reduce volatility or greatly enhance volatility.
Let’s look at our example trade on $100 underlying stock on a $10,000 account. We could buy 100 shares of stock for $10,000 as a base case and use all our capital and we have market risk all the way to zero with a Delta value of 100.
If we set up one contract of the poor man’s covered call like our above example, we risk $750 and have the equivalent of 50 shares of stock, so much less volatility and downside risk, while still controlling a notional 100 shares through our contracts. Our loss is limited to $750, which will occur if we hold our long to expiration with a stock price change of more than 7%. This becomes a very conservative trade compared to owning stock or a traditional covered call, if we keep the rest of the account in cash.
If we trade two contracts, we have 100 Delta in total portfolio for a cost of $1500. At this point, our volatility is the same as 100 shares at the current price. However, our loss is limited to $1500, not $10,000 like stock. But now, we lose 15% of the account value on a 7% down move as we are controlling 200 shares of notional value through 2 contracts. We also get double the benefit to the upside compared to one contract. We also get double the Theta of a covered call, or a single contract of a Poor Man’s Covered Call. So the trade acts like stock when the price stays close to the opening price, but shows some leverage on moderate price moves. Arguably, one could say the extra benefits of leverage are worth the potential added risk to the downside- we still are only risking 15% of the account value, not all of it.
What if we take the trade to an extreme? We can easily do 10 Poor Man’s Covered Call contracts for $7500 cost. Our Delta increases to 500, so we get 5 times the movement of owning 100 shares, and our ten contracts now control 1000 shares of stock, a notional value of $100,000! With all this leverage, we get huge Theta. We also get a lot of volatility. If the stock goes up 1%, we make 5%, but the downside is the opposite. The big risk is that we can now lose 3/4 of our account if the stock goes down just 7%. Now we’ve made this trade into a virtual roulette wheel, big wins or big losses. Our probability of profit is still over 50%, but we’ve taken on a huge risk. Our max loss is a move down of just one standard deviation, which is not that unlikely. In fact, if we trade like this for very long, we will surely hit max loss within a small number of trades. We can potentially limit worst case scenarios by cashing out when the going gets tough, but that goes against natural instinct and can be hard to follow as a plan. The bottom line is that this would be a clear example of way too much leverage.
The point of these capital use examples is to show that a trader has to really understand the advantages and risks of leverage in a trade like this. The same trade can be very conservative, or extremely risky, depending on the context of the account it is in. So it is up to each trader to evaluate how the combination of trades affects the performance of the full account. You can read more about these concepts in my write up on Portfolio Management.
Assignment Risk
Since the Poor Man’s Covered Call involves selling calls, there is always the potential for those calls to be exercised by the buyer. With an actual Covered Call, the exercise means the covered shares are sold to fulfill the contract. But with a Poor Man’s Covered Call, there are no covered shares, just a long call in the money. Assignment in this trade means that the account has to sell shares that aren’t in the account, so the account holder will end up with short shares plus cash from their sale.
From our example we have been using, let’s say that the stock goes up to $105 and the short call of our position gets exercised by the owner of the call. We wake up the next day with -100 shares of stock and $10,300 added to our account. And we still have our long call contract well in the money. It’s a mess. A lot bigger mess than just having our long stock sold, because there are more moving parts. But it’s a good mess, because our positions have made a nice gain, especially our long call.
We can untangle our mess by buying our short shares back. We can also sell our long call at the same time to get a clean slate and then decide whether we want to open new positions at Deltas that are closer to where we’d like to be. So it isn’t that hard to straighten everything out.
In my write-up on Covered Calls, I wrote a long section on how to avoid assignment. The discussion is the same for this trade, so I won’t repeat it. Read the Covered Call write-up if you want to explore those tactics. There’s really less concerns about assignment with a Poor Man’s Covered Call because eventually the long call needs to be sold or rolled and the combination of the two can be re-positioned together if needed.
Final Thoughts
The Poor Man’s Covered Call has a lot of advantages compared to owning stock and selling calls. The trade provides a bullish outlook with positive Theta decay, while limiting risk to the downside. It typically has a greater than 50% probability of profit, while being a debit trade, which is rare in options trading. The trade does provide leverage, so care must be taken in managing the size of the position within any account.
The Covered Call can be done in almost any account, requires no extra capital if you own 100 shares of stock, potentially increases portfolio income, and reduces volatility of returns.
Most discussions of options start with the Covered Call. The Covered Call can be done in almost any account, requires no extra capital if you own 100 shares of stock, potentially increases portfolio income, and reduces volatility of returns. What is not to like?
What is a covered call?
For those not familiar, a covered call is a trade where the owner of stock, sells a call for that same stock. This can also be done with exchange traded fund (EFT) shares. The risk of selling the call is “covered” by the shares that option owner has. The worst thing that can happen to the call position is that the stock price goes up and the call is exercised and the shares are “called” away.
Let’s look at an example. Say we own 100 shares of a stock currently trading for $400 per share. We can sell a call with a strike price of $420 expiring in 6 weeks or 42 days for a premium of $2.00, and collect $200 (1 contract is 100 share times the premium). By selling a call, we agree to sell our 100 shares for $420 any time in the next 6 weeks if a call buyer exercises the option. We don’t have a say in it, only the buyer does. But, if it happens, we also keep the $2.00 premium we just collected, so the total profit would be $22 over the current $400 share price, a 5.5% gain in 6 weeks or less. More likely, the call option will expire worthless if we don’t do anything and we keep the $2.00 premium and the 100 shares. That’s the proposition, and the potential outcomes from holding until expiration. And most people who discuss selling covered calls end the discussion with that, but this site is written for data-driven option traders, so let’s dig in deeper.
Below is a profit chart showing the profit profile at different points in time. One thing to notice is that the all the lines near the current price see to be close to parallel, or tracking with the expiration profit and the profit from just holding 100 shares alone. Those two lines are parallel, with the difference being the $200 that was collected when the call was sold.
However, if we look closely the lines representing the value at 28 days and 21 days aren’t quite as steep. This is because the time value varies significantly over different underlying prices. Initially, the Delta of the call being sold is 0.20, signifying that its value will change by 0.20 for every dollar the underlying stock changes in price, and meaning there is a 20% chance it will expire in the money. I find it easier to think of the our Deltas in whole numbers representing 100 shares, so our 20 Delta calls that we sold combine with the 100 Delta of the underlying shares to give us a net Delta of 80. So initially, our total position is going to move up or down $80 for each dollar in price that our stock changes. That means our position is only 80% as volatile as owning stock outright.
Covered calls improve the probability of profit over owning stock alone in exchange for giving up unlimited upside.
Another thing to notice is that even after a few weeks, the position has a profit even in a small $1 decline in stock price and is ahead of stock alone for the first several dollars in price increase compared to owning stock outright. So, if the price doesn’t move much, we have a profit and a better profit than owning stock. This is a nice outcome when the market doesn’t move.
A big move down is still a big move down for our total position, we just lose $200 less than we would have if we hadn’t sold the call which is only a small consolation if the stock drops 10 or 20 percent. As the market goes up, the position makes money, but we have an upper limit based on the strike price of the call. A quick move up increases the Delta of the call and keeps the overall position value well away from the expiration value until we get to expiration. So, at big moves, we have virtually unlimited risk to the downside and limited profit to the upside, which seems a bit backward.
If you sell covered calls much, you’ll have a number of situations arise of extreme moves in one direction or the other that can be very frustrating. This situation really turned me off from this strategy for a long time until I focused into probabilities more and worked out my management strategies. Before we get into those, let’s break this trade apart to see how each component behaves individually and see how that might make you think twice about the strategy.
Here we see the profit profile at different prices and times for just the call that is sold and the underlying shares.
Anyone who isn’t a fan of the covered call can point to a graph like this to help explain what there is to not like about selling a call. The issue is that in a big up market the call can lose a lot of money- all the money that the stock is making, and that is money that is then gone through the short call. We could have had a big profit from owning stock, but now we don’t. Before we get to feeling too sorry for the trader in this situation, we need to back up and remember that we didn’t actually lose money, the trade is a profit, just not as profitable as if a call hadn’t been sold.
Particularly in bull markets, selling calls outright is often a losing strategy over time. Even though the trade has a relatively high probability of profit, the losses of the lower percentage of losers can be much bigger than the gains. Run backtests and it is hard to find a naked call selling strategy that is profitable over time. So, one might decide to skip the call selling and just stay long. But we are talking about covered calls, not naked calls, and the stock portion of the trade make a difference.
I’ve read lots of books and articles about how selling calls is like creating a bonus dividend on stock- make an extra 5-10% per year by selling calls on stock that you already own. The actual results would say that maybe with good management, a covered call seller will beat the buy and hold seller. Just don’t expect selling calls to be a get-rich-quick scheme. It isn’t.
What can be done to improve results of selling covered calls? First, we need to have a mindset to look at the true benfits of selling covered calls. Next, we need a toolbox of management strategies for dealing with the ups and downs of selling covered calls. And finally, we need realistic expectations of the type of results that can be achieved. If we do all these things, we’ll find selling covered calls to be a satisfying strategy.
Benefits of Covered Calls
Selling covered calls has three significant benefits-reduced volatility, additional income, and improved probability of profit. Let’s take them one by one.
Trading options can be used as a way to influence the volatility of the returns of a portfolio. Most people think that options are extremely risky, but it really is a matter of how they are used. Selling covered calls is a way to reduce risk by reducing volatility. If a trader has 100 shares of stock, the position goes up or down $100 for every dollar change in share price of the stock. If the owner sells a 25 Delta call against those shares, the total position will now move only $75 up or down for every dollar change in stock price. Voila, a less volatile position! While a 25% reduction in position volatility may not be that much, it is a reduction. Taken with other steps to manage the overall Delta of a portfolio, every action contributes to the final result.
The obvious benefit of selling covered calls is additional income from the call premium collected. But it isn’t how much premium we collect when the trade is opened that matters, but how much we keep when the trade is closed. I’ve said that this trade can be tough to show a profit from the calls themselves, so what is a reasonable profit target from the sales of calls? Generally, if a covered call seller can hang onto 25% of the call premium collected on average over time, that’s a successful outcome. As mentioned earlier, the challenge is that most of the time, the amount kept will be more, but occasional moves up will take big losses on the call portion of the trade. These losses are offset two ways- the long stock goes up when the calls lose value, and the calls shield some of the losses of stock on down moves.
The nature of the trade is always one side is winning while the other side is losing. But there are also situations where both sides of the trade can win at the same time. Small increases in price allow the stock to go up and the short call option to decay in value with a little time passing. Looking at the original profit chart, we can see that the net profit is positive on both up moves and slight down moves, which makes the probability of profit greater than 50%. We can improve the probability by managing the trade early before the underlying price moves far from where the trade opened. This is one of several management strategies to consider.
Managing a Covered Call
As with all option trades, we have our typical choices for managing- hold, fold, or roll. But there are a lot of different scenarios that can impact our decision making, depending on price movements, implied volatility changes, and the approaching payment of dividends. There’s also philosophical strategy choices around whether a trader wants to let shares be called away, or avoid options being exercised. All these various considerations make it a somewhat complex menu of management choices for the trade that is often considered the most simple option trade of all.
Most covered call sellers I know or have read about consistently have covered call positions against their long stock. It isn’t something they sell for a while, then stop and start randomly. More than any other option trade, covered calls are a commitment to ongoing trades. The question is what that commitment is for each trader.
There are some traders that sell covered calls only when their stock is trading at high levels. The thought is that it isn’t likely to get much higher, and so it’s a good time to pull in some extra income. But what is high? And what is low? Whatever the market outlook, covered call traders need management strategies.
As mentioned earlier, most management strategies fall into the categories of hold, fold, or roll. With covered calls, holding means holding the calls until expiration or assignment, and dealing with the outcome. Folding would imply getting out when there is a win or a loss beyond a set amount, but most covered call sellers aren’t stopping when they hit a trigger, they want to keep trading. So, that leaves us with rolling, where we move from one call to another to another, collecting all the premium we can over time. I’m going to focus on holding strategies and rolling strategies as they make the most sense for covered calls.
Holding and Wheeling
When a trader sells a covered call, the default way to manage is to hold until the option expires or gets assigned. Many traders like this way of managing because of simplicity- just let the market play out. For stocks with less liquid options, frequent trading isn’t practical. Outside the most traded 100-200 most active stocks, there are few strikes to trade and lots of stocks with only monthly expirations. Many stocks don’t have any monthly expirations beyond around 45 days, so rolling month to month isn’t a legitimate choice until expiration anyway. So, if a trader is selling covered calls on a basket of stocks, many of the options can only logically be managed by holding until expiration or very close.
If a covered call is held to expiration, there are two outcomes. It expires worthless or the call is exercised and the shares sold for the strike price. The outcome determines the next step for most traders.
If the option expires worthless, most traders will turn around and sell another call option. Since options expire at the end of the week, this means selling on Monday of the following week or soon after to get as much premium decay as possible in each expiration cycle. Perhaps a trader will choose a strike and enter a limit order to try to capture a little extra premium on a small up move. If the option expired worthless because of a big down move, it could be a good time to evaluate whether to continue owning the stock or whether it makes sense to sell calls with the stock price so low.
Most covered call sellers try to avoid selling calls at strikes less than their basis price. For example, if a stock was purchased for $100 and a $110 strike is sold for $2.00, and the stock drops to $85 a share, the option will expire worthless and the trader’s cost basis becomes $98. If the trader now finds a good option to sell has a strike price of $95, this might be a no-go because there is no way to make a profit. Or it might get some premium back against the paper loss incurred. The trader has a decision to make.
I typically look for new strikes with a Delta between 20 and 30 for covered calls. I want to get good premium, and it’s okay to take on a higher probability of expiring in the money because my call is covered. Other traders sell much lower Deltas, trying to reduce assignment risk. It’s a personal choice- how much assignment risk does a trader want to get paid for.
When a covered call gets exercised and the stock is sold at the strike price, the seller has a few ways to proceed. If the stock was one that the owner was happy to be rid of, it is a good time to do something else with the capital that was freed up. But if the trader wants to get back in the position, a common tactic is to move to the next step of a Wheel strategy.
The Wheel strategy deserves its own writeup, but the covered call is part of this common covered strategy. The wheel is a cyclical strategy of selling covered calls and cash secured puts. Here is the basis steps of the Wheel:
Sell a cash secured put out of the money.
As long as the cash secured put expires worthless, sell another cash secured put.
When a cash secured put is assigned into long stock, sell a covered call against the stock.
As long as the covered call expires worthless, sell another covered call.
When a covered call is exercised, and the stock is sold, sell a cash secured put to restart the cycle.
Many traders like the Wheel strategy as it tends to force them to buy low and sell high. Puts get assigned when stock prices go low, and calls get assigned when stock is high. For many option traders, this is “the strategy.”
Rolling Continuously
Another approach is rolling positions regularly, well before expiration. The goal is to get a nice chunk of time decay, then close the position and open a longer-dated position for a net credit. A side benefit is that assignment of the call can be mostly avoided by frequent rolling. The strikes can also be adjusted with each roll to stay close to optimal Deltas and probabilities.
Not all stocks and options are optimal for rolling. Good underlyings for rolling calls need to have good liquidity with lots of strikes, good option volume, and frequent expirations. I like stocks that have weekly expirations because they tend to have good volume and lots of choices. These stocks tend to have weekly expirations out up to six weeks, and monthly expirations every month for several months out.
As mentioned earlier, I like to sell calls with Deltas between 20 and 30. With rolls, I look for new strikes in that range where I can collect a net credit. That isn’t always possible, so we need to consider the various scenarios that can arise, and have a plan for each.
Let’s start with the easiest scenario- the stock price doesn’t change. In our earlier example, we sold a 420 strike at 42 DTE for $2 when the stock was trading at 400. Two weeks later, the premium has decayed to $1 and the stock is still at 400. We can just close our current call and sell another 42 DTE call at 420 for $2, and have a net credit of $1. We made $1 profit on a $400 stock in 2 weeks- a 0.25% return while lowering risk and the stock didn’t change. If we could do that every two weeks, we’d have an extra 6.5% return in a year. We just need the stock to cooperate with our plan. But we know that it isn’t that easy, prices change.
Rolling up when the stock goes up
When underlying stock prices go up, calls increase in cost and the Delta gets higher. The goal of each roll becomes trying to move the strike price up to get a Delta a little lower while still collecting a credit. Looking at our earlier example where a call was sold at 420 when the price was 400, let’s assume that after 2 weeks, the stock price has gone up to 410, a 2.5% increase, which would not be unusual at all. Our call has gone from a value of $2 when we sold it to $4 because it is closer to the money. If we roll back out to 42 days at a 420 strike, our new Delta would now be 40, higher than we like. If we roll to 430, we would have a 25 Delta, but we would have to pay a debit because of the premium cost difference. However, we find that we can sell a 425 strike for $4.20, 20 cents more than our current call will cost us to sell, and the Delta of the new call would be 34, closer to where we’d like to be, but not all the way. It’s a compromise. We can collect a net $0.20 credit and move our strikes up a bit. This would be my choice.
One reason I don’t get wound up about getting all the way to my target Delta is that I know that stock prices go up and down. So, while my Delta is high on this roll, if the market goes down, the Delta will come back to where I was targeting. I somewhat expect that, but I really don’t hope for that, because I get much more portfolio movement from my stock than from my call. Remember that when the price went from 400 to 410, and the call went from $2 to $4 in value, the net of that move was $8 profit- a $10 gain from the stock against a $2 loss from the call. The price move up is always a good thing when we have a covered call, even if the call’s value is a loser for us.
But what if the price keeps going up and the call keeps getting more expensive and our calls end up in the money, or even deep in the money? No matter how far the stock goes, our calls are a combination of intrinsic and extrinsic (time) value. The time value of the call is always decaying. We can always roll out to the same strike for a credit, and usually we can roll up a little as well. Let’s say our call that we started with in our example gets to a point where it is $20 in the money and has a value of $22 with 28 days left to expiration. We look around our choices to roll and find that any roll up two weeks further out will not get us as much premium as we have to pay to close, so we see that we can sell a call $19 out of the money for $22.10 with 49 DTE. Is that a good deal? I think so, because we are locking in a dollar more value if the option were to be exercised while collecting 10 cents to do it. As our calls get deeper and deeper into the money, the chance that our stock gets called away goes up, so every strike price increase we can get with a roll improves the price our stock could get sold at.
How long do we keep this up if we get deep, deep in the money? At some point, we may find that there aren’t calls that are liquid around the strikes we are trying to roll to. That’s when it’s game over for me. I’ll stop rolling and let the call get exercised and sell the stock. I’ll have a nice profit on the stock from where I started, and re-evaluate what to do. Maybe I’ll wheel back in by selling a put, or maybe I’ll look for another opportunity in another stock.
Rolling down when stocks go down
Rolling down as stock prices go down is actually a little trickier and can be a trap. The issue is that while the call makes money when the stock goes down, the stock loses several times more value. As an option trader, the challenge is to step back and see the big picture. We can’t just look at our call profit, but the total position as we strategize going forward.
A key consideration in managing rolls down is looking at the cost basis of the overall position. If our earlier example was that we started by buying stock at $400 a share, we start with a cost basis of $400 per share. If we then sell a call for $2, our total cost basis is reduced to $398. Every call we sell reduces our cost basis. Let’s be clear. This isn’t our cost basis for tax purposes, but for how we might choose to think about our overall trading position. The IRS looks at the profit and loss of each individual trade, not how trade after trade impacts your total net costs. But many traders like to think about the total capital they have spent and collected to evaluate whether to continue with a strategy.
So putting this concept to use, let’s say our stock that we’ve been discussing throughout this write-up goes down from 400 to 390 in the two weeks after we opened the trade. Our 420 call price drops from $2 to $0.25 with a Delta of 5, almost worthless. Should we roll down? We could roll to a new 410 strike 42 DTE call selling for $2. 410 is above our cost basis, so if the stock went up beyond 410, we’d still have a nice profit, so why not. We can collect a net credit of $1.75 and reduce our net cost basis to $396.25. We’ve done great on the call, but remember our stock lost $10 per share, while we only made $1.75 on the call.
If the stock bounces back from here, we would tackle the position with a roll up strategy like we just discussed. But if the stock keeps going down, we can keep rolling down.
Let’s say that after our roll down, the stock drops to 375 after another two weeks and our call drops to 10 cents of premium. We look at 42 DTE strikes and find that we can sell a 395 strike for 2.10 because IV has increased from the drop in stock price. Is this still a good deal? If we sell this call, our net cost basis will now drop to 394.25 while our strike is 395. If the option were to be exercised at 395, we’d have a small profit, so if we still like the stock, this trade could still make money.
If we take another hit to the stock price, any rolls of similar price differences at the times we have been trading will need to be sold below our cost basis. If we want to keep our strikes above the cost basis, we can go further out in time, or take a lot less premium at lower and lower Delta values.
If we follow the stock further down with even lower strikes we enter into a lose/lose situation. If the stock keeps going down we lose, and if the stock goes up beyond our strikes we also lose because we are likely to have to sell for less than our net cost basis.
By this point most traders will either abandon selling calls on the stock, or dump the stock and find something else to trade. Every trade needs a plan, and one part of the plan is knowing what you will do in a big loss- is there a price that enough is enough? As we’ve discussed at other points, the biggest mistake most traders make is taking small profits on winners, and holding onto big losers- a recipe for a losing portfolio over time.
Big moves up and down can be tricky to manage for covered call holders, even stressful. But considering that compared to holding stock alone, a covered call seller is still in a less volatile place.
Avoiding Assignment
Is there a way to know if a call that we sold is going to get exercised by the buyer? Most of the time it’s pretty clear cut, but occasionally it is luck of the draw. Put yourself in the shoes of the call buyer-when would it be a no brainer to exercise your call option? In the money at expiration is generally automatic, but early exercise is usually driven by either an event in the next day that makes a buyer want to lock in a profit, or a need to close out a call that has become illiquid. Let’s go through these scenarios and see how to avoid being on the other side of the trade.
This section assumes that a trader wants to avoid assignment. As explained earlier, there are lots of traders and individual situations where a trader is satisified or even desires to have their stock called away. If you want to have your short calls exercised, do the opposite of this section’s advice and keep your calls in values that are subject to assignment.
A quick overview of the mechanics of assignment. Options are managed by an options clearinghouse. Option buyers have the “option” to exercise their option contract at any time prior to expiration. The buyer notifies their broker that they want to exercise an option and the broker notifies the clearinghouse. The clearinghouse then randomly matches up the requests to exercise options with short option contracts that are currently open. The clearinghouse assigns these contracts to sell their shares to the option buyers who have exercised their option. Option owners typically have until 5:30 PM Eastern Time, or an hour and a half after the market closes to notify the broker they want to exercise their call. The actual transaction generally is done around midnight while the market is closed. Key points are that it is up to the buyer, happens when the markets are closed, and is random.
Expiration Assignment
If a call is in the money when it expires, it almost certainly will be exercised by the buyer. Most brokerages automatically exercise all their customers options that expire in the money as a courtesy and also to save the administrative hassle of having every option buyer request the option to be exercised.
The logic is simple. The stock is worth more than the strike price, so it wouldn’t make sense to not exercise the option and buy the stock for less than the current price. That was the point of the buyer in purchasing the call option to begin with, to make money when the stock went above the strike price.
Occasionally, an option might expire right at the strike price or a penny or two in the money. Some option buyers may choose not to exercise because of the costs outweighing the benefit of buying the stock at a lower price. Or some news may make it clear that the stock will be worth less when the market opens the next day, make exercising a losing proposition. However, these scenarios are very rare, and a trader shouldn’t expect or count on them.
Just because a stock expires out of the money doesn’t mean that it won’t be exercised. When there is positive news after the close, and option buyers anticipate that the stock will open above the strike price, they can still exercise the option after the market close but before the clearinghouse assigns options to be exercised. If a call option buyer has a call with a strike price of 420 and they expect the stock to open at 421 the next day, they can exercise the option buying at 420 and sell the next day for 421. If you are on the other side, you shouldn’t be surprised, it happens.
How do we avoid all these expiration assignments? Simple, don’t hold options to expiration. Close or roll out options before they expire. Even if your plan is to hold to expiration and then sell another, you can close the expiring option on expiration day and sell a later expiring one at the same time, so you can keep getting decay over the weekend, since expirations generally happen at the end of the week.
Even if a call is in the money, you can roll it out in time and not get your stock called away at expiration. There is still early assignment risk and we have ways to greatly reduce early assignment, but expiration assignment is generally automatic.
Early assignment due to dividends
Probably the most common reason for call buyers exercising an option early is dividends. On the day that a stock goes ex-dividend (when owners of stock are credited with an upcoming dividend payment) there is a big benefit to being a stock owner vs a call owner. The upcoming dividend payment is baked into the stock price prior to the ex-dividend date and comes out after it. Call values also reflect this in pricing.
If a call owner has a call with a strike price in the money or within the amount of the anticipated dividend and less than the extrinsic (time) value of the option, they will execute the option every time. In fact there are traders that will buy options at the close of the day before a stock goes ex-dividend to immediately exercise for a profit if the arbitrage opportunity exists. It usually doesn’t because the market is very efficient.
There are two ways to avoid assignment on ex-dividend day. Have a call further out of the money than the dividend amount, or a call with more extrinsic value than the dividend. Let’s look at each situation.
If you have a covered call that has a strike price close to the current stock price, you are likely to be assigned. If however, the call is well out of the money, it won’t be exercised.
For example, if a stock is trading at $400 a share and you have sold a $420 strike call with a $3 dividend being credited the next day, no call buyer will exercise because they would have to pay $420 to own a $400 stock with a $3 dividend, a value of $403. Why spend $420 when the stock can be purchased for $400?
On the other hand, if the stock price is $400 and a call buyer owns a $401 strike call when a $3 dividend is being credited, then the option can be exercised to buy a stock for $401 that has a value of $403. Good deal for the buyer, right? Maybe- it depends. It depends on the extrinsic value of the call option. And you thought covered calls were a simple topic?
The extrinsic (time) value of a call impacts whether it makes sense to exercise or not for a dividend. For example, if a stock goes ex-dividend tomorrow trading at $400 today with a $3 dividend, would it make sense to buy a $401 strike call for $4 and exercise it? The buyer would pay a total of $405 to get a $403 value, a loss. On the other hand, if there were a $401 strike selling for $1, buyers would line up for blocks to buy as many as possible to pay $402 for a $403 value. In practice, prices wouldn’t work that way, because stock prices are varying while the market is open and option prices are adapting to make capturing a dividend on a stock close to a break-even trade as ex-dividend day approaches. So, you won’t find an option priced lower than the combination of stock price and upcoming dividend, but you can find options more expensive than the combination. What determines whether it is the same or more? Time value.
Extrinsic or time value of an option can make a call option more valuable to hold than to exercise to capture a dividend, even in the money. In our previous example we discussed a $401 strike call with a value of $4 vs. $1. What determines the difference in prices? Time and to a degree implied volatility. We can’t do anything about implied volatility- it is whatever it is. But we have total control over the time value of our covered call option.
The further out our covered call is from expiration, the more time value it has. So, if we have a call with a low amount of time value, lower than the coming dividend, we can roll the call out in time to make it have more time value than the dividend. The greater the difference in time value vs the upcoming dividend, the less likely the call will be exercised.
If we have a covered call with a strike price near or in the money, we can avoid assignment by rolling to a point in time where the extrinsic/time value is more than the expected dividend. It doesn’t guarantee that a rogue call owner won’t exercise for a loss, but it becomes highly unlikely.
As an example, if we have sold a 390 covered call trading for $11, expiring in two weeks, and the current stock price is 400, and a $3 dividend is expected to be credited to owners of record the next day, we are in position to have our stock called away. Why? Because our combination of strike price and call value is $401 (390 + 11) and the value of stock plus the dividend is $403 (400 + 3). Any owner of a call would cash in their call option for stock and collect the dividend. However, if we roll out 6-8 week further in time and keep our 390 strike but have a call worth $15, we are likely safe to keep our stock. Our $15 call has a $10 intrinsic value (400-390) and a $5 extrinsic value (15 -10). The extrinsic value is more than the $3 dividend. Seen another way, the call strike price and value now total $405, $2 more than the value of stock plus dividend, so it’s not a good value to exercise the call. Generally, if we have a covered call within a few weeks of expiration at or in the money, it will be exercised on the night before an ex-dividend date. Calls significantly further out in time will be safe.
For calls deep in the money, it can get difficult to go far enough out in time to have enough extrinsic value to be greater than the coming dividend. I once had a covered call stock run away from me to the upside, and I rolled my calls over and over. Eventually, my strikes were 25% below the stock price. Even with calls 6 months out in time, I had very little extrinsic value, almost all the call’s value was intrinsic. The Delta of my call was almost 100, so I had capital tied up that wasn’t going up or down hardly at all, no matter what the stock did because my call’s price moved almost exactly opposite of my stock. I decided as a dividend approached that it was time to let my position get called away, because I didn’t want to roll out 6 months further to get more premium. Sometimes, we just run out of ways to keep the position alive.
What timeframe for Covered Calls?
Throughout this write-up I’ve used 42 DTE as an example for writing covered calls. Is this optimal, or is there better durations? Generally, I like starting around 6 weeks and not letting my positions get within 3 weeks of expiration. I can adjust every few weeks or so, and I don’t have to watch my positions constantly. There’s good decay, at least enough for me.
Trading closer to expiration means faster decay, but more volatility in prices. For traders that can manage the additional changes in price, this might be fine. This is a covered call, so the worst case scenarios aren’t that bad, especially if the plan is to hold to expiration, or if the plan is to “wheel” the position.
Trading farther out in time allows for even lower volatility in exchange for less premium decay on a daily basis. Selling covered calls with more time to expiration can allow a seller to sell strikes farther out of the money as well for the same Delta value, giving the position more cushion in an up move. More time is generally equal to less stress.
The right strike for selling Covered Calls?
In addition to choosing a timeframe for selling covered calls, a trader has to pick a strike to sell. I tend to choose strikes with Deltas between 20 and 30 for covered calls, which is inside the expected move. Because I plan to roll well before expiration, I will likely roll before the stock will end up in the money. The calls are covered by stock, so I’m not particularly worried about my calls getting into the money on occasion.
Other traders are more conservative in choosing call strikes and want to be well outside the expected move. They will give up much of the premium to keep the probability of their call from getting in the money. There’s a somewhat popular book on selling covered calls that recommends 12 as the right Delta for selling a call. The author never says it, but 12 Delta is more than a one standard deviation move at expiration, and so it is “likely” that the call will expire worthless. If that’s the goal, then that’s as good of logic as it gets.
On the other side, if a trader wants out of a position, the value can be maximized by selling a call at the money and having a high probability of having the position called away. A “wheeling” trader might want a high delta especially when prices appear to be peaking, to sell the stock before it starts going down. The higher the Delta, the more the call counters the stock, reducing the position volatility. It’s depends on the trader’s goal for the trade.
Final Thoughts
Trading options is all about making choices of trading one position for another, trying to move to a position that has better probabilities of profit, or less risk, or some other variable that is important to the trader. We can see there are lots of ways to trade what many would consider to be the most straight-forward option trade of all, the covered call.
Buy stock at a big discount? This strategy is often referred to as stock replacement. We buy calls, have the same upside as shares of stock but at a fraction of the cost. Look for two things: relatively high probability and low Theta decay.
Want to buy stock at a big discount? This strategy is one that is often referred to as stock replacement. With this strategy, we can buy options that have the same upside as shares of stock but at a fraction of the cost. In theory any time someone buys a call, there is the same upside as stock, but some setups give a trader more of the upside benefit than others.
When I think of using options in place of stock, I’m looking for two things, relatively high probability and low Theta decay. When buying a option with no hedge, the natural way to lower time decay is to buy a call well out in time where it will decay slowly. To get it to move with the underlying stock, having an in-the-money option can get most of the move up (or down).
So for this strategy, I look for options 6-12 months out with a Delta value of 75-80. These options will likely cost 10-20% of the cost of the shares as they have significant intrinsic and extrinsic value. With over 6 months until expiration, time decay is slow, but still present.
In this example, a call is purchased with 9 months (273 days) until expiration with a Delta of 0.78. Notice that even after a month or even three months, the profit curve is very close to that of owning stock around the money. Notice that the downside is significantly less than stock.
Because I’m buying an option with a Delta of 75-80, I have the equivalent of 75-80 shares of stock from a price movement stand-point. If the price goes up, over time the Delta will increase and the option will behave closer and closer to the movement of 100 shares of stock.
The risk to the downside is limited to the amount paid for the options, so a big market drop could wipe out the position, but even a big drop would still likely hold some value, but mostly the extrinsic time value. However, the really good news is that losses in the options on a downturn are less than the losses that would come from 100 shares of stock.
My goal in this trade is not to hold until expiration, but to either exit or roll to a longer duration before we get into the last quarter before expiration. If the stock price has gone up, I can roll to a new time at a higher strike price and collect the amount the stock has appreciated less the time decay that was lost.
This trade needs a small move up to break even, so the theoretical probability of profit is a little less than 50%. But, by getting out way before expiration, the odds get ever closer to 50/50, and in a bull market the unlimited upside with limited downside is a pretty compelling proposition.
One watchout with this trade (and other long call option strategies) is thinking that since we use just one fifth or one tenth of the capital of buying stock that we can now buy five or ten times as many options and really cash in. We have to respect the downside risk. A big move down will wipe out this position. So we don’t want to put all our eggs in this basket.
But when the market is frothy and looking like it is going nowhere but up, this is a good way to participate in the upside while protecting the downside, assuming that there’s plenty of capital left to deploy if the market suddenly goes against the position.
What level of option risk goes best with what type of underlying security? Depending on the option strategy, your choice of underlying security type can have a big impact on your outcomes.
What level of option risk goes best with what type of underlying security? Most people reading this might wonder what in the world is the point of this topic and why should I care? Depending on the option strategy, your choice of underlying security type can have a big impact on your outcomes. This might get a little deep, but hang with me and I think it will be worth your time.
Level 0: Covered options- cash secured puts and covered calls
Level 1: Buy options
Level 2: Option spread trades- buy an option, sell an option
Level 3: Naked option selling
There are also four general types of underlying securities for trading options. With each comes different advantages and disadvantages. As a reminder the four types are:
So the question and point of this post is to examine which risk permission levels work best with which types of underlyings. It’s not an obvious question or an obvious answer. Most traders would say it doesn’t really matter- more risk is more risk, and less risk is less risk. But some underlyings are better built for certain strategies more than others. It doesn’t mean you can’t trade a strategy for a certain underlying, it is more of a question of what is optimal for the type of risk and potential return you are seeking in a trade.
The Matrix
I made a sixteen square matrix to evaluate each combination. I rated each pairing based on how well the option risk matched with the characteristics of the underlying. My conclusions are simply my opinions, and I welcome discussion and other opinions backed by data. So here is my matrix and what follows is the data and logic behind it.
Some types of option strategies and risk are better suited for certain underlying securities than others. With each combination is a brief explanation. Green choices are best.
Let’s review the boxes one row at a time, by risk level.
Covered Options
Covered or secured option strategies include covered calls, cash secured puts, covered strangles, and the wheel strategy. These strategies use the full value of underlying shares either in cash or shares to protect against loss from selling short options. The options being sold are much less volatile than the value of shares, so covered options are the only option choice that is a clear reduction in risk compared to owning shares outright. All versions of this option trading strategy limit upside growth while allowing the potential of losses to zero, but most of the time these strategies outperform owning stock outright. So how does this type of transaction impact different underlyings?
Individual stocks can be very volatile. Positive or negative news about earnings or products or lawsuits or mergers or management changes can make stocks move way outside their expected moves. These outsized moves happen more often than normal statistical distributions would predict. Even so, individual stocks tend to have options with much higher implied volatility than the overall market. For stock investors that want to dampen day to day moves of their portfolio balances, selling secured or covered options is a great way to participate in individual stocks with less drama. Because of the crazy volatility of individual stocks and the high implied volatility of options on individual stocks, covered options are a great match for individual stocks.
I would argue that for both the covered strategy and the stock underlying type, this is the strongest match in this row and column. There is no better underlying for covered options than individual stock, and there is no better option risk level for individual stock. I know a lot of people will disagree, but as we look at the other combinations, I hope you’ll at least understand my point of view.
Covered options on exchange traded funds are fine trades. It’s probably the safest possible option strategy there is if we want to call any kind of trading “safe.” We combine a bunch of volatile stocks together into a product that dampens volatility down substantially. Then we sell options against that new product that will rarely see moves outside the moves that are expected. The options may not pay a lot, but they won’t lose often either. A very boring way to make steady gains (and I’m thinking of boring as a good word here).
An argument could be made that covered options on ETFs is perfect for both, because it’s a double volatility reduction, and for risk-averse traders that’s a great combination. I get that, but for me, I think it’s a little too much volatility reduction, and sacrifices too much option premium for safety. Be less volatile with stocks by selling covered options, or be less volatile with riskier option strategies by using ETFs, not both. But I’m generally a risk taker, so maybe I under-appreciate the double volatility reduction of covered option strategies with ETFs.
Covered options on indexes is the easiest combination to rate on the matrix, because it is the one combination that can’t be done. We can’t own an index outright, so we can’t sell a covered call. If we sell a put and get assigned we don’t get the index, we just pay up the cash we lost. So, there isn’t a real way to sell covered index options on the underlying index. This is the only red square in the matrix because it can’t be done.
Covered options on futures can be done, but it doesn’t really make sense. Futures and futures options are all governed by span margin, so really there isn’t an official way to sell covered options on futures, because there is margin being used on every leg of the trade. No piece is fully “covered.”
I almost made the covered futures options block red, but you can kind of do it if you set aside the cash that the full notional value of the future is worth when you sell a call against a future, or sell a put on a futures contract. The problem is that your buying power won’t show that you’ve locked up the full notional value, so you have to track it yourself. It just isn’t what futures are about.
Let’s do a quick example to illustrate. Let’s say we have a futures product that trades for $1000 with a multiplier of 50. So the notional value of a contract is $50,000. If we buy a futures contract, the broker will use SPAN margin and only take away at most $10,000 of our buying power, even though we are on the hook for the full $50,000. If we sell a call on the same future, we’ll likely gain buying power, as we just reduced the volatility of the position. Maybe SPAN margin says we now only need $5,000 buying power, while we remain at risk for $50,000. So, our broker and SPAN margin don’t make us “cover” our options. You can keep $50,000 in your account to cover the trade yourself, but nothing forces you to, other than wanting to eliminate any risk of blowing up your account in a downturn. It’s fine to do this, but it technically isn’t a covered option, so it’s a yellow square on my matrix.
Buying options
When most people first learn about options, buying an option is the trade they can easily understand. You pay a premium to have the option to either buy or sell something. Margin is not a factor, because the risk is defined. The risk of the option is the cost, it can end up worthless, a total loss, but no more than what was paid to own the option. If the option ends up in the money, it may be profitable, maybe very profitable. Leverage comes from the possibility of virtually unlimited profit for a relatively low cost.
Buying puts or calls is like going to the security market casino. It’s a low probability bet that might pay off big, but often will lose what you gambled. But let’s not get all “judgy” against the strategy- lots of directional traders buy options to get the most out of a move they think will come. When implied volatility is low and the market is rolling up nice gains, it can be a very lucrative trade that exceeds its predicted probability. But which underlying security types are best fit to take advantage?
Individual stocks can make big moves up or down, and owning an option in the right direction when a big move happens can be great! But the market knows that individual stocks are prone to big moves so options are expensive to buy. A little move won’t cut it. A trader has to be very right on timing and direction.
But, if buying calls or puts is your thing, the biggest rewards are with individual stocks. So, I’ll give it a green square.
Buying options on ETFs is cheaper than stocks, but the likely moves won’t be as big. However, if the goal is to ride a trend that is going up faster than what implied volatility predicts or a slide going down, ETF long options are a good choice.
In a bull market, selling calls is usually a loser, which means that buying calls can be a winner. Buying calls on an ETF in a bull market will hit a lot of winners usually without a lot of capital required, so probably the best use of the strategy in this row.
Buying put and call index options is a very similar situation as options on ETFs. It’s really a matter of preference, depending on several factors. Some brokers restrict access to index options, so it might not even be a choice for some accounts. Most index options are bigger notional value, often 10 times as big as the equivalent ETF, so it might make more sense for a bigger account to use index options, while smaller accounts stick to ETFs. There are a lot more ETFs available than index options, so niche indexes either don’t have an index option or have such poor liquidity that the only choice is an ETF. Commissions per contract are often higher on index options, but per notional amount are lower. So, it depends on a lot of things. I’ve discussed the differences in much more detail in my write-up of different ways to trade the S&P 500. All the same trade-offs are true for the Nasdaq 100 and Russell 2000. So, for some traders buying options, the index option might be best so I’m coloring the combination green, but for most traders smaller, more liquid ETFs are going to be a better choice.
For futures options, the issues are similar as comparing index options to ETF options, except that buying futures options outright negates much of the advantages of futures options, but keeps the negatives. Futures options are a favorite of experienced and sophisticated traders because they can be traded with lower SPAN margin requirements, giving a trader more leverage, and also letting opposing positions reduce buying power. But, if a trader is only buying options, buying future options doesn’t gain much in buying power, but will cost a lot more in commissions and slippage from lesser liquidity than ETFs or index options. In my opinion the only time it makes sense to buy a futures option is to counter a bunch of short futures options or other futures position. I talked about this in my discussion of buying the 1 DTE straddle with futures options.
In the end, unless you have a really good reason to buy options on futures, it generally is a better trade to buy a similar ETF or index option product. So that’s why I colored this combination yellow.
Trading Option Spreads
Let’s define an option spread as buying and selling an equal number of puts or calls. There are a lot of ways to trade spreads, and many of my favorite strategies fall in this broad risk category. Option spreads have defined risk, but as strategies get more complex, understanding exactly how much risk a trade has defined can get a little tricky. It isn’t as obvious as the risk with buying an option, but the risk is known.
We can think of spreads in two main categories, debit and credit spreads. Debit spreads are trades where a trader pays to enter the trade, and credit spreads pay the trader to enter the trade. Credit spreads are often the highest leverage version of selling options, with the highest potential return on capital for many positions. With that potential high return on capital comes the risk of a total loss, often many times the amount that was collected to open the trade. How do these factors impact different underlyings?
With individual stocks having more likelihood of an outsized move, there is a bigger chance of a total loss on a credit spread, although that is somewhat balanced by higher premium from higher implied volatility. Debit spreads tend to limit max gain in exchange for improved probabilities compared to buying options outright. So, debit spreads on a individual stock miss out on big gains without a outsized increase in probability of profit.
Many traders favor spreads for individual stocks over naked options because of the defined risk limiting losses to a defined amount. My view is that both strategies have to contend with outsized moves and it’s a matter of picking which poison does the least damage. But because so many like spreads as a risk reduction for individual stock options and it is a viable strategy, I’ll rate this combination a yellow.
I’m going to lump ETF options and index options together for spreads. Just like with the earlier discussion on buying options, the difference between ETFs and indexes is a matter of preference and an individual’s account situations. Strategically, I like both for buying and selling spreads. Because ETFs and indexes are made up of many stocks, they have much fewer out-sized moves than individual stocks. This makes the leverage of spread trading work well, both in credit and debit type spreads.
As for buying spreads, I’ll occasionally buy a call spread when the market is particularly bullish and Implied Volatility is low. Buying options in any style is usually a low probability trade, but there are ways to improve odds, and using a spread to have decay on the short leg off-setting the decay being lost on the long leg can be a big help. We can get more exotic with diagonal trades selling a nearer term option while buying a longer term option and actually having positive Theta for our trouble. In all these trades I like ETFs and indexes because the results tend to be more consistent.
Many of the ratio type trades that I do utilize two sets of spreads, like the popular broken wing butterfly trade. Again, I like ETFs and indexes because outsized moves are less likely than individual stocks.
You may be sensing a theme. Less outsized moves make using the highly leveraged option spread on ETFs and indexes my favorite choice for spread trades. It’s green squares for both, and my favorite use of ETFs and indexes, as well as my favorite way to trade spreads.
In theory, futures option trades with spreads should also be as favorable as ETFs and indexes. They work about the same and have the same type of probabilities. But there are two things that I don’t like about trading spreads on futures. One is a personal nit-picky concern, and one is a concern that virtually any trader would have.
Let’s start with the most legitimate concern. Futures options are less liquid than ETF and index options. They have wider bid-ask spreads, and they are harder to fill close to the mid price between the bid and ask. In many trades, the tick size, or the amount you can adjust your limit price by is substantially bigger than for the same trade on an index option on the same thing. For example, on $SPX index, we can adjust our limit orders by 5 cents up or down, but with /ES futures, we have to adjust our order in increments of 25 cents. To make it worse, often the volumes are much lower and even giving up 25 cents won’t get an order filled. So, it can cost a lot to get filled, and we haven’t even talked about commissions, which are generally also higher, both per contract, and even more so as percentage of the notional value of the position. Maybe someday these costs will get lower and it won’t bother me as much, but I just don’t like it for spreads with futures options.
But what about SPAN margin you might ask? Doesn’t that extra margin make it palatable to pay a little more so you can get that super-duper leverage for traders that like more risk and more reward? Well, this is my nit-picky problem with spreads on futures. SPAN margin isn’t that much extra buying power for spreads with futures options compared to indexes, ETFs, and individual stocks. Because spreads have defined risk, the two sides of the trade already have formed a hedge and SPAN margin doesn’t give much more buying power than the reduction from calculating the max loss of the total spread being wiped out. To be fair, futures traders get some additional buying power, but it isn’t enough for me to justify the higher costs of trading spreads with futures options.
I know there are traders out there that like futures with spreads that little extra buying power that comes from SPAN margin, but for me it makes more sense to go with an index option or ETF option where my risk is defined and doesn’t change. So, I’m giving this spot on the matrix a yellow. Proceed with caution.
Selling Naked Options
Selling naked options is supposed to be the riskiest of the whole bunch of risky option trades. In one way it is in that maximum losses are essentially undefined, but even with margin, the leverage of Theta or Delta as a percentage of buying power is often less than what happens with spreads. So, as long as we avoid outsized moves (which we can’t, by the way) there’s a strong argument that selling naked options is not nearly as risky as it would seem at first glance.
Let’s be clear about what selling a naked option is about. With covered options, we can sell a call or a put and there is either cash or shares covering the short option positions. For naked trades, the broker lets us sell on margin. Often we are only required to have something like 20% of the notional value set aside for covering the option sale. That’s great for our account as long as the price doesn’t move against us more than that 20%. Actually, the broker will increase buying power requirements as price moves against a position, so the requirements are always in flux. But with plenty of extra cash as a buffer and markets not going crazy, it’s manageable.
So, we are selling options on margin. What underlying type does this work best with? Let’s check out our four choices.
Individual stocks are the most likely underlying to have an outsized move, so they are the most likely to get a naked option trade into trouble. It doesn’t take much, a change at CEO, a merger or acquisition, surprising earnings announcements, good or bad product news- any of these can trigger a move way beyond the expected move. With individual stocks, the probability of an outsized move both up or down tends to be greater that what Delta would predict, or it often just isn’t that great compared to the other products with diversified components.
That’s my reason for avoiding naked options on individual stocks. I know lots of people trade naked options on stocks all the time, diversifying their holdings to reduce overall risk. But for me, why not use an underlying that is already diversified? I know individual stocks have higher Implied Volatility to pay a seller to take on that added tail risk, but for me it just isn’t enough. I’ve seen too many situations where a trader has gotten a very nasty surprise and lost way more than they thought they could. It can happen with any naked trade, but it’s more likely with individual stock options. So, for me this is a yellow box- proceed with extreme caution.
Now, let’s not try to make the argument that naked options on the other types of underlyings are super safe. They aren’t, and you can lose big. Ask anyone who had naked puts on the S&P 500 (any version) when Covid hit in 2020. It was bad. But those kinds of moves happen much less often than negative moves in individual stocks. People that trade naked options take a lot of risk, and so the question for the remaining three underlying types isn’t which one is least risky, but which gives you the biggest bang for the buck? If you are selling naked options, you better know what the risk is, but how do you maximize return when you have a trade go your way?
Like the last two levels of risk, ETFs and index options have essentially the same pros and cons for naked options. While there is significant tail risk, it isn’t as high as individual stocks. So, naked options sales on ETFs and indexes tend to perform better than the expected move would predict. This makes these underlyings a better choice for underlyings on naked options. As a result, I’m giving these matrix squares a green rating.
Finally, we have selling naked futures options. On one hand this is a highly leveraged trade with ultimate tail risk due to SPAN margining. On the other hand, this combination gives a trader the potential for significant high returns on high probability trades that otherwise might not make sense.
I look at naked futures options as the ultimate “go big or go home” trade. If a trader wants to trade futures options, selling naked gives the ultimate amount of exposure for the least buying power. SPAN margin allows a trader to use a fairly small amount of capital to open a naked trade. And if a trader balances the Delta of both sides of a trade, buying power requirements become even less, as the total risk is considered in required capital.
SPAN margin also lets a trader have different sides of the trade be at different expirations and have the net exposure of each side be considered in the SPAN margin calculation. The point is that for the most agressive, risk-tolerant option trader, there is no higher leverage way to sell options than selling naked options on futures. For that reason, I really like futures for naked options.
Selling futures options naked still have the issue of poor liquidity and higher commissions, but the flexibility of SPAN margin finally makes it worth the cost for risk-tolerant traders. It is worth noting that the liquidity and commissions are significantly more of an issue for traders that trade “micro” versions of futures options, like /MES, compared to /ES. Whether it is a futures product on an stock index, a commodity, or a currency, the micro versions just have a lot less open interest and liquidity. So, if account size limits trades to micro futures, a trader has to watch which expirations and strikes can be entered and exited without huge price slippage, particularly when exiting early.
Despite the cost issues with futures options, selling naked futures is my favorite use of futures options, and my favorite way to sell options naked. I give it a green box on the matrix. I don’t rate it this way to suggest it is a safe trade, but that it is the ultimate use of options leverage.
Bonus sections
There are a few option strategies that don’t fit neatly into the four categories of risk that I think deserve a special mention because I talk about them in other parts of the site.
Bonus #1 Ratio Style Trades
Ratio style trades are a more complicated type of strategy where there is an unbalanced number of contracts sold vs bought- a lot of times a 2:1 ratio in some variation. If there are more contracts sold than bought, the trade becomes a level 3 naked trade, like the 1:1:1 or 1:1:2 put ratio trade that I discussed in other pages. But often, I use a level 2 defined risk version of the trade by adding long options to equal out the short options, usually creating a wide credit spread along with a narrow debit spread, like a broken wing butterfly (1:2:1), broken wing put condor (1:1:1:1), or 1:1:2:2 put ratio.
These trades are technically either a group of spreads (level 2), or a spread with a naked short option (level 3), but is there a difference in what underlyings are best for these kinds of trades because of the ratios and odd ways of managing these types of trades? The short answer is not really.
For level 2 defined risk ratio trades like butterflies, condors, and 1:1:2:2 trades, I like ETF and index options for their liquidity and reduced volatility. This is the same logic as with spread trades in general.
For level 3 naked versions of ratio trades where there are more short options than long, my preferred underlying is futures options due to the reduced buying power of SPAN margin. These trades tend to be fairly highly probability of profit, but with significant tail risk from black swan type events. SPAN margin considers this risk and allows a trader to use a fairly small amount of capital to enter this kind of trade. Anyone trading this way must consider the significant tail risk into their management strategy.
A trader can use ETF or index options for these naked ratio trades, but they consume a lot of capital with standard option margining. Traders with portfolio margin accounts might find this more acceptable. For understanding of different types of margin in options, see my post on the topic.
Bonus #2: 0 DTE trades
0 DTE trades have special considerations because of their short time frame. Let’s throw in 1 DTE and any options trade that has just a few days until expiration. All these trades focus on either last minute moves or the extreme decay that comes in the final days or hours of an option contract.
Individual stock options don’t have daily expirations, so expiration day trades are usually limited to Fridays or end of month at most. That essentially eliminates them as a candidate, but it gets worse.
With options near expiration, assignment at expiration or near expiration is a big concern. Individual stock options and ETFs in the money can be unexpectedly assigned into shares in the days before the options expire. And if options are held to the end of the expiration day, assignment can happen even if the market closes with options out of the money. A late after the market news event could trigger option holders to exercise their options on individual and ETF options, so you never know.
So, that leaves index and futures options. Index options are settled to cash at the market close. Futures options expire into futures contracts at the market close. A trader doesn’t have to worry about after market events impacting an expired position. The only exception to this is monthly index options that settle on the open of the market, but stop trading at the market close of the previous day. These contracts have AM expiration, where almost all other options expire in the PM, at the market close. The ticker symbols for index options expiring and settling at the market close generally end with a “W” for weekly, which originally was for the weekly expirations that happened every week, but now happen every day. The monthly options, which are the very original index options, don’t have a “W” at the end of their ticker indication.
Settling to cash vs settling to futures contracts or shares is a big difference. Most expiration day traders don’t want to deal with the underlying securities ending up in their account and the significant notional value that comes with them. Because of that, index options are far better choices for trades approaching expiration.
Traders with small accounts can choose between micro index options, like $XSP, micro futures options like /MES, or ETFs like SPY. They have different pros and cons. Micro index options have fairly poor liquidity with wide bid/ask spreads and big tick sizes for poor fills, but settle to cash at expiration. Micro futures options have worse liquidity and bid/ask spreads, plus high commissions, and settle to futures contracts, all negatives, but are usually half the notional size of the other two low capital choices. ETF options tend to have good liquidity, but settle to shares at expiration, or after expiration. None of these are ideal, but if a trader wants a small option stake on expiration day, these are the choices to consider.
Conclusion
So, there you have it. A fairly exhaustive analysis of the various combinations of trade types vs underlying security types. Some of the factors I consider most important in this analysis, may be less important to other traders, and some accounts at certain brokers may not even give a trader a choice to have some of these types of underlyings available. Others may not have some risk permissions available.
In any case, my hope is that whatever level of risk or underlyings a trader has available, it is clear what combinations make might more sense from a viewpoint of risk, potential reward, capital usage, and trading costs.
