option trading Archives - Data Driven Options Trading

A 112 Cautionary Tale

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.

5 Bullish Call Trades

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?

Here are five call trades that I like:

Sell a Covered Call (yes, it is actually bullish)
Buy a Long-term Deep in the Money Call (the stock replacement trade)
Buy in the money longer duration call and sell short duration out of the money call (Poor Man’s Covered Call)
Ride the up trend with an Out of the Money Call Debit Spread– double up and reset
Buy Call Back Ratio for Credit and Zero Extrinsic Back Ratio (ZEBRA) trades

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.

buying a long-term call in the money has almost the same profit potential as buying stock, but for a fraction of the cost. — 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:

The two legs of the diagonal spread that make up a Poor man's covered call. — 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.

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.

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.

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.

I discuss the ins and outs of both of these back ratio strategies in the extended post on this topic.

Conclusion

Buy an Out of the Money Call Spread

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.

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.

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.

The Poor Man’s Covered Call

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.

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.

Rolling a Poor Man's Covered Call can mean moving the legs independently. — 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.

Replace Stock with a Call Option

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.

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.

Trading Options with a Full Time Job?

Most people have full time jobs. Can someone manage an options portfolio and work full-time without watching the market all day? I say yes.

Most people have full time jobs that don’t involve the financial markets. Can someone manage an options portfolio and work full-time without watching the market all day? I say yes, and they may do even better than a full time trader. The reasons may surprise you.

For several years I was a full time options trader, watching positions in a bunch of accounts, adjusting every day as the markets moved. Many of my positions were short duration, which meant that I needed to stay on top of them. Much of my strategy involved rolling to avoid getting to expiration or to keep my strikes out of the money. There were lots of good reasons to spend the day reviewing every position in every account to determine if any adjustments were needed. And I enjoyed it. It was fun managing accounts that were growing and generating the income I needed.

But in 2022, I had a series of events that drained my accounts that provided my spending money. (Separately, I’ve written about my lessons learned in 2022.) I’m not yet to the age where I can take money out of my retirement accounts without penalty, and I didn’t want to get into Substantially Equal Payment Plans (SEPP) to commit to withdrawls- that’s a big topic for another day in itself. The bear market coincided with some unexpected expenses, so I liquidated most of the liquid accounts I had available at bad times. My accounts that had been providing nice streams of income lost a lot of value when I needed them most. So as the year came to a close, it was clear I needed to get a “real” job again.

Changing to a full time “real” job

In January of 2023 I started working full-time, a typical 9-to-5 job. But I still had a number of accounts to manage, a combination of retirement accounts and leftovers from my cash/margin accounts that I hadn’t completely used up. (I didn’t go broke, I just wasn’t flush enough to live off my accounts that I could draw from.) I had to have a different approach to account management- the days of full-time trading were over.

I still wanted much of my portfolio to be option-based. I’ve seen how options give me leverage and the ability to manage in any type of environment. But I knew that my approach to managing daily had to dramatically change. I couldn’t watch the market and do my job, so I needed to completely change my trading routine.

First, I decided to stop all 1 DTE and 0 DTE trades. Honestly, these had not been that profitable and were the most time-consuming positions I had been trading. It was almost like I had been trading them to keep my day completely filled with activity. If you read about my 1 DTE Straddle management approach, you’ll see that I try to take profit and adjust positions throughout the day, which is very time-consuming. 0 DTE trades are just as time-consuming for most strategies. I know some traders open a position and set up stop and profit limit orders and go about their day, but even that seemed like more than I wanted to do. So, no more expiring option trades.

Next, I moved all my shorter duration trades out in time. I was doing some 7 DTE put spreads, rolling almost every day. These were problematic in the 2022 bear market anyway, so it wasn’t a hard decision to get rid of them. I also decided to mostly stop doing 21-day broken butterfly trades. This was a harder decision, as I’ve had good success with defending these even in tough times, but I knew that I just didn’t want that responsibility to keep an eye on them.

So, I was left with positions mostly 4-7 weeks from expiration- put spreads, iron condors, covered calls, covered strangles, some 1-1-2 ratios, and some long duration futures strangles. All these trades are far enough out in time that a move during the day won’t be a huge loss or need an immediate adjustment.

Initially I thought I’d try to spend a half hour each morning when the market opened before I started my job. For a few weeks I did this, but I found that my work often required me to be available for an early call during that time, or there were urgent items that couldn’t be delayed, and that time wasn’t available. I’d miss a day, then it was two or three in a row, and I realized I needed to be able to have an approach that could go several days at a time without requiring action. But, I also noticed that missing several days wasn’t hurting my market results, especially in a choppy market.

Since almost all my trades are based on profiting from premium decay, time is my friend. I need time to pass and the market to remain somewhat stable. Getting away from the daily noise of the market up for some reason one day and down the next for another reason helped remind me that selling options is about being patient. It also reminded me that market movements are mostly noise that is statically insignificant. If I don’t react to every move, the market tends to chop up and down and not really move that much or that fast over time, which is exactly what a seller of options needs.

My new routine

With time, I’ve settled into a trading routine of doing a thorough review of all my positions about once a week. For positions in the 4-7 week to expiration window, I like to roll and adjust Delta about once a week, essentially kicking the can down the road, trying to pick up a percent or two of return on capital each time. Timing isn’t critical, but I want to keep my spreads in the sweet spot where they decay the most, with short strike’s Deltas in the high teens to low twenties. I’ve written about this in many posts that address best Deltas for put spreads.or for rolling put spreads. I’m leaving a bit of money on the table, missing the very best timing, but I’m making up for that by not over trading, which I clearly was in 2022.

Some of my longer duration trades, that are 2-4 months out, can go weeks or even a month or more without an adjustment roll. My weekly checks just make sure that they are not getting close to being tested or getting to a duration that I want to extend. My philosophy with those positions is an “if it ain’t broke, don’t fix it” approach. So, not much to do with these.

So, it takes me about an hour a week to make adjustments during market hours. I find a break in my day, or a day when I can get trades in early before my work day starts. I’ve been surprised at how manageable it all is. I’ve realized that when the day comes that I don’t need a job anymore, I will be able to manage my trades with a lot less time than I was using the last several years. I don’t plan to ever trade all day long again.

Results

The great news is that I’m very happy with my results. My most aggressive accounts have been pulling in about 10% returns each month so far in 2023, and all my accounts are handily beating the market. So, I’m very happy with my new approach. I know that the market isn’t always this calm, but I also know from 2022’s bear market that longer duration trades in high volatility have much better outcomes than short duration trades, so I’m confident that this approach would have done well in that environment, better than I did trading every day with short duration trades.

The Covered Strangle

A covered strangle? It’s a conservative three component trade made up of long stock and selling both a put and a call out of the money.

What’s a covered strangle? It’s a three component trade made up of long stock, selling an out of the money call, and selling an out of the money put. It’s a high probability trade that is less volatile than owning all stock, but uses a lot of capital keeping returns somewhat limited. It’s a great way to ease into strangles, which typically are reserved for very experienced traders. It can be traded in almost any account because it only requires Level 0 option permission approval, so most retirement accounts will even allow it.

A covered strangle? It's a conservative three component trade made up of long stock and selling a put and a call out of the money call. — A covered strangle is bullish, making money when prices go up.

Technically, a covered strangle is a combination of a covered call and cash secured put, two strategies that are a favorite of many conservative option traders. It’s “covered” by stock on the call side and cash on the put side. Let’s say we have 100 shares of the SPY ETF trading at $400 per share, a value of $40,000. We can likely sell a 420 strike call a month out for about $2.00 premium or $200 total for the 100 share contract. If we have another $38,000 cash in our account, we can sell a 380 strike put for around $4.00 premium or $400 for the contract. We’ll likely collect a little around 1.5% of our capital at risk. We have $40,000 in stock and $38,000 in cash securing our strangle. We can hold to expiration and let the chips fall where they may, or my preference of managing early and rolling out for more credit.

A trading friend has been talking up covered strangles to me for years. Honestly, I’ve looked past it as it seemed like a boring trade that takes a lot of capital for a somewhat small return. At first glance, there’s limited upside because gains are capped by the call, and unlimited (to zero) downside. If the stock price goes up, the call can be triggered and the stock sold for the call strike price. If the stock price goes down, the stock and the put both lose value. And we are doing this for a 1.5% return on capital? And this is supposed to be a good conservative trade? Actually, yes! Let’s dig a little deeper and see why.

Probabilities, Volatility and Manageability

There are three major factors that make this trade desirable. First, there is a better than 50% probability that this trade will deliver a profit. Second, this position is significantly less volatile than being fully invested in stock. And finally, strangles are one of the most forgiving trades to manage, allowing continual repositioning, or a variety of other trade variations if held until expiration or assignment. As a bonus benefit, we are invested in stock, often with dividends, and over time the market tends to go up for a gain. Let’s review each benefit in detail.

Probabilities of Profit

If we look at our example trade mentioned earlier, let’s assume that we are selling a 20 Delta put and a 20 Delta call. We can quickly see that if held to expiration, there’s a 40% chance of one of the options expiring in the money- 20% for the call, and 20% for the put. If the concept of Delta matching percentages is new to you, refer to my webpage on Delta. But even if an option ends up in the money, it doesn’t mean the trade loses. We can look at it from just the stock, just the strangle,or the full covered strangle.

The stock itself is a slightly better than 50/50 proposition. On average, we expect to see a bit better than 0.5% return per month. But that’s on average. Our expected move for a month tends to average about 4%. (See the page on Expected Move if this is a new concept.) So, a lot of up months and a lot of down months, but we also expect the stock to stay inside the strike prices of the options sold. Historically, our monthly probability of profit is between 55 and 60%. Individual stocks may have somewhat different probabilities than indexes, but most are in this range.

Profits of a Strangle, 100 shares, or 200 shares — This chart illustrates the profit contribution of the strangle components and the 100 share components. For contrast 200 shares profit is also shown. Notice that only the strangle profit changes with time passing- the shares profit only based on price changes.

The strangle of a short put and short call have well defined probabilities. While the probabilities of ending in of the money are 40% at expiration, we also have to consider that we have collected premium that gives us an additional cushion before we actually lose money. In our example, we have collected $6 premium and have strikes $20 away from the current price. We don’t lose money at expiration until the stock price ends up over $26 away from our starting price. A quick check of options Deltas will show that we have about a combined 25% probability to expire over 26 points away from our starting price, so we have a 75% probability of at least some profit from the strangle. If we manage early, we can improve this probability to an even higher rate, reducing the possibility of an outsized move blowing through our strikes.

If we do some basic math, the average probability of the stock and strangle would be a little better than 65%, based on our probabilities of each part of the trade. But there’s a little more subtlety to probabilities of the covered strangle, due to the interaction of options and stock. On the upside, we could be assigned and have our stock called away if the market goes up more than 5%. We’d make $2000 on our stock plus keep the $600 option premium we collected, a $2600 profit on $78,000 capital, a 3.3% return. No matter how high the stock goes, our gain is capped at 3.3%. On the downside, our stock starts losing money immediately, but we still have our $6 premium collection that buffers our total position down from $400 to $394 before the covered strangle is at a loss at expiration. The put doesn’t add to the loss at expiration until it is in the money, but below that both the stock and the put lose equal amounts as the price declines. If we check the option table, we have somewhere around a 38% probability of our stock expiring more than $6 below our start price, so actually we have a 62% probability of profit for the full covered strangle.

If it wasn’t already clear, the covered strangle is a bullish trade. Up moves are always profitable, and the only way to lose is a market decline more than the total premium collected. That shouldn’t be a surprise, owning stock is bullish, a strangle is neutral, and the combo covered strangle is still bullish.

We’ve discussed in other posts that Delta actually overestimates moves and that probabilities are actually higher for profit, especially on the put side of the trade as put buyers buy up insurance to protect from big moves down. Since our risk is to the downside, our probabilities actually are a little better than Delta might suggest.

From this discussion, you can see that there are a number of ways to think about probabilities with a covered strangle. The takeaway should be that probability of profit is high. In a bit, we’ll talk about how management can help improve our odds even more. But first, let’s talk about how a covered strangle reduces portfolio volatility.

Portfolio Volatility Reduction

It should be somewhat obvious that when we combine a pure bullish strategy of owning stock with a neutral strategy of a strangle, we have a combined strategy that is somewhere in between. Let’s compare a covered strangle to being fully invested in stock.

100 or 200 shares vs Covered strangle — Comparing the profit and loss of a covered strangle to 100 shares or 200 shares of stock shows more profit if price doesn’t move much and less change with price overall. The only time that being fully invested in stock outperforms is when there is a large move up.

Using Delta to represent equivalent stock (another way Delta can be used), 200 shares of stock has a 200 Delta value. A fully neutral strangle paired with 100 shares of stock has 100 Delta value. Both positions use the same capital, but the all stock position will move up and down twice as much day to day as the covered strangle. Delta will vary from neutral as the underlying price changes, reducing with price increases and increasing as prices go down. So, position volatility will go up if the underlying price declines, and vice versa. It should also be clear that the strangle and the stock behave differently, and that difference diversifies the price response of the covered strangle.

You might think that with a decrease in position volatility, we would be giving up a lot of potential return. But actually, we can expect as much as 0.5% average return per month from the strangle, about the same as the stock. But since one side of the covered strangle is likely to do better in each point in the trade, returns are likely to be more consistent than either by itself.

Managing Strangles

Of all option trades, strangles are about the most manageable of all strategies. Both the short put and short call can almost always roll out in time for a credit, whether the strike is in or out of the money. With spread type options, only out of the money strikes can collect credits from a roll. For single short options, there is no long strikes to buy back.

The Strangle portion of the covered strangle — The Strangle portion of the Covered Strangle is profitable at expiration when prices stays inside the expected move.

I like to use rolls to recenter my strikes around the latest prices. Going back to our example, if the underlying price went down to 390 after a couple of weeks, we should be able to roll our strikes out a few weeks more with 370 put and 410 call, and collect a credit. The idea is to use rolls out to just keep collecting credit. Compared to rolling spreads and iron condors, there’s way more forgiveness, and more likely profit even in moves that test the strike prices of either option. Sometimes, I may pay a debit on the tested side to move the strikes well out of the money, and collect a bigger credit on the untested side and move the strikes closer to the money when they are very far away. Even if my strangle position is showing a loss, I can usually still collect a credit and keep the trade alive and let time decay the increased premium.

My goal is to consistently collect credit from rolling the strangle as the underlying stock goes up and down. Using SPY at around $400 a share, I’ve recently found I can roll out weekly from around 25 DTE to 32 DTE and collect a $2 premium net credit, or about 0.5% of my cash secured capital. A year of that would be 25% return, which would make most conservative traders very happy. I can’t do that every week because sometimes a big move sends my positions into a tested area where I need to adjust strikes to recenter and the net credit is smaller.

Many traders don’t mind the assignment either way and happily wheel between covered calls and cash secured puts, but I like to try to keep both options of the strangle in this situation if I have the capital available to support a position. The strategies aren’t that different, but with a covered strangle, I can adjust easily no matter which way the market goes, and not have to buy and sell my shares of stock.

Assignment due to dividends is a possibility, which I find as a minor annoyance, but actually manageable. Remember that the calls are covered, so worst case when a stock goes ex-dividend and is close to being in the money, it will get called away. Then, a trader can use the wheel strategy and sell a put to get the shares assigned back. I avoid this by adjusting strikes so my calls are far enough out of the money that it never makes sense for an assignment to occur. I also don’t hold options that are near expiration and most likely to get assigned, especially at dividend time. But again, since the calls are covered, there is no real risk, just the selling of shares for a profit.

Level 0 Strangle?

Brokers have different levels of option trading permissions. I’ve written about this in my pages on different levels of risk and comparing risk. Level 0 is the lowest level of risk and easiest for a trader to be permitted. Most brokers consider covered trades as Level 0, although some brokers may have a different name for it. The reason most consider this option permission level as zero is because it is actually less risky than holding the same amount of stock, whether the position is a covered call, a cash secured put, or a covered strangle. That means less risk for the broker and for the trader. This makes covered option trades a favorite of conservative traders.

Since we are talking about strangles, how different is the risk of a covered strangle from a margined and naked Level 3 strangle, or a futures option naked strangle? The big difference is that there is nothing covering the risk in either direction with higher risk levels of strangles. There is absolutely no limit to the risk to the upside. Prices can keep going up, and a naked short call keeps losing no matter how high prices go. On the downside, most brokers only require around 20% of the capital at risk for a trade to be executed. So losses can greatly exceed the initial capital in a big downturn. In contrast, a cash secured put can’t lose more than the cash required at the start of the trades, because 100% of the value of the stock that would be assigned at the strike price has to be in the account. The highest strangle risk is from using naked futures options which utilize SPAN margin, and even less capital required, which also means even more potential for crazy losses if the market gets out of hand.

Because Level 0 covered strangles have several times less risk than naked Level 3 strangles, they provide a great way to get used to trading strangles. Traders can get familiar with the mechanics of strangles without the risk of naked positions. And covered strangles are still a viable way to make a return on investment that often beats the market, particularly in flat and down years.

I’ve written about different types of underlying securities, but covered strategies including covered strangles can only use stocks or ETFs, because a trader can’t own an index. Stocks and ETF are familiar to most all traders, and many aren’t even aware of index or futures options, so covered strangles mean nothing new to learn.

Probably the biggest issue for trading covered strangles is the amount of capital required. For my favorite ETF underlying, SPY, trading at $400 a share, the shares alone are $40,000 and selling a cash secured put ties up approximately another $40,000. So, for the smallest 1 contract increment of a covered strangle, a trader needs $80,000. For many traders, this is out of reach. A low priced stock might be more of a practical choice, so Ford Motor (F) trading recently at around $12 a share needs about $2,400 to get a covered strangle going.

Because individual stocks typically have more implied volatility than ETFs, there is more premium to collect, making individual stocks good candidates for covered strangles. Since the trade is covered and risk is slightly less than owning stock outright, it can be argued that covered strategies are best used with individual stock. Assignment is more likely in individual stocks because outsized moves are more likely, but the position is covered by cash and stock, so assignment is just a feature of holding a covered strangle. For traders who haven’t experienced assignment on a naked position or spread, assignment on a covered position is a much less stressful way to be introduced to the concept.

It may appear that I’m portraying the covered strangle as a beginner option strategy, but it is really a sophisticated method of reducing risk. Most people are scared of options because they are considered risky. The covered strangle is one strategy that uses options to reduce risk compared to owning equivalent shares of stock. Many conservative investors utilize covered strategies, not to speculate, but to lessen the volatility of their returns. Most financial planners will give you a deer-in-the-headlights look if you ask about this strategy even though it reduces risk and should be a common tactic. But most financial professionals are completely unaware of ways to use options to reduce risk. So for that reason alone, don’t ever think of covered option strategies, including the covered strangle, as a beginner strategy. I think of it more of a way to be fully invested and sleep better at night strategy.

0 DTE Option Trading

Many people are buying and selling options with zero days to expiration (0 DTE in option lingo). But is this a good idea? Are there strategies that actually work? Or is this just gambling? Well, like many things in options, it depends. There are strategies that have been successful with years of history, and we’ll dig in to discuss them.

In 2022, the option exchanges rolled out options on a few indexes that expire every day of the trading week. This has caused a frenzy of option trading by individuals who are trading a variety of expiration day strategies every day. Many people are buying and selling options with zero days to expiration (0 DTE in option lingo). But is this a good idea? Are there strategies that actually work? Or is this just gambling? Well, like many things in options, it depends. There are strategies that have been successful with years of history, and we’ll dig in to discuss them.

Over the past several years, the frequency of option expirations has increased dramatically, particularly for the major indexes, the S&P 500, the Nasdaq 100, and the Russell 2000. Initially, there were only monthly expirations that expired on the third Friday of the month. Options expiring every Friday were added several years ago, and Monday and Wednesday were added a few years back, and finally in 2022, Tuesday and Thursday expirations were added. Trading volume has grown exponentially, and trading on options expiring within the next few days are now the majority of option trades. Clearly, expiration day trading is very popular.

I’ve been exploring trading strategies for expiration day for several years, going back to when we started having expirations available for Monday, Wednesday, and Friday. I’ve discovered that 0 DTE is not for everyone, can have many elements of gambling for many, but has a few strategies that have a positive expectancy of profit.

Things to know about 0 DTE

First off, 0 DTE requires a different mindset than longer duration trading. Profits and losses explode in minutes, making the importance of having a plan critical. Options in general require strategies and planning, but 0 DTE is significantly more volatile. So, for traders that can’t handle huge swings in value over very short periods, 0 DTE may not be a good place to go.

For traders that do trade 0 DTE, I highly recommend keeping a log of all trades to be able to evaluate whether the strategy being used is actually working. Some trades have fairly high win rates, but have big losses when they lose- a log will help a trader determine if the wins outweigh the losses over the long run. Also, keeping note of what went well and what went wrong will help a trader learn from success and failure. I can tell you that most traders that fail do so by not sticking to their own rules for managing risk.

One key consideration is the Pattern Day Trade Rule that applies to accounts with less than $25,000. Federal regulations prevent small accounts from opening and closing the same position the same day more than three times in any 7 day period. Doing so will place severe limits on the traders account. If you have an account with $25,000 or less, or even just slightly more, you need to be very aware of this rule and how it works before even thinking about 0 DTE trading or any short duration in and out trading strategies.

There are a number of ways to trade 0 DTE. Some traders try to get in and out, while others hold a trade to expiration at the close of the day. Some are net buyers of options, what I will call debit trades, while other are net sellers, or credit traders. I say “net” because many strategies involve trading spreads, buying one option and selling another, generally the more expensive being hedged, protected, or partially financed by the cheaper option.

When options are expiring at the end of the trading day, all the characteristics of options are sped up. From a data driven standpoint, there are three key Greeks to consider. The two most obvious are Theta and Gamma which essentially battle it out for the day. But Vega also plays a key role, as big moves spike up Implied Volatility and option’s premium, and calmness can sap premium almost as fast. With hours or even minutes until the options expire, the Greeks’ calculations stop meaning as much as the concepts behind them.

Options sellers are banking on Theta eating away the premium as the day progresses. If the option ends out of the money at the end of the day, it is worthless. On the other hand, Delta will end the day at either 100 or zero and is likely to swing huge amounts during the day, which is the measure of Gamma, the change of Delta. So option buyers are looking for options to get in the money and run way up in value.

Since we are talking about expiration, it is important to understand the implications, which vary depending on what underlying the option is based on. Remember, there are four types of underlying securities, and at expiration the differences really stand out when an option expires in the money. For stock and ETF options, in the money options are settled with shares, which may not be the best outcome for day trading. In addition, while expiration option trading ends at the closing bell, expired stock and ETF options can be exercised until midnight, so even options that end trading out of the money still might be exercised if market conditions change after hours from news or earnings impact. Index options are much more straightforward. Index options are cash settled based on the price of the index at the closing bell. Because of this, index options, like SPX, are generally the preferred trading vehicle for traders holding options through the closing bell. Futures options settle with futures contracts unless the futures contract is also expiring the same day. However, futures options are assigned based on the price at the closing bell, not any after hours moves, so a trader knows at the bell whether there will be an assignment or not. So switching between underlying types for 0 DTE trades in not a trivial decision.

As mentioned before, because 0 DTE trades can rapidly change in value, having a mechanical trading plan becomes critical for consistent success. Most traders that trade short/selling strategies use stop losses to keep losses from getting out of hand, and long/buying strategies use some type of trailing stops or rolls to protect winning positions and keep upside unlimited. There are a few trades where holding to expiration (no matter what happens) could be considered, but I think 0 DTE are best managed by active trading based on market action.

So let’s get to it. Let’s discuss some typical strategies, both from the long and short side, considering what it takes to be successful.

Selling options with 0 DTE

Most 0 DTE option sellers I know actually sell spreads to define risk. Selling naked options on expiration day simply requires too much capital and carries too much risk for the average trader. The width of the spread can vary based on the strategy or capital available to the trader, but wider spreads tend to decay faster than narrower spreads. These trades are expected to win a high probability of the time, but to avoid severe losses, stop losses are also critical parts of the strategy.

While there are many variations of these strategies- different times to enter and exit, trading one side or both sides (puts and/or calls), entering or exiting all at once or legging in based on the market, the core of the strategy is the same. Sellers want to sell at a relatively high premium and buy it back for less or even let it expire worthless. I’m going to focus in on two common strategies that I have had success with and 0 DTE trading friends have done successfully- a wide Iron Condor and an Iron Fly. For discussion, let’s assume that we are selling spreads directly on the S&P 500 Index, ticker symbol SPX.

0 DTE Iron Condor

Iron Condors on expiration day seem to perform best way out of the money, selling options with 10 Delta or less and buying 30 to 100 points further out of the money. Greek calculations for 0 DTE can be flaky and vary widely, so many traders are more comfortable choosing strikes based on the premium available. For example, a trader may sell the lowest put strike that sells for over $1.00 or maybe over $1.50, and buy the put that sells for under $0.75 or $0.50. For perspective, you can estimate the expected move at any time in the day by adding the premium of the at the money put and at the money call. Generally, these strikes are between 1.5 and 2 times the expected move for the put being sold and another half expected move further for the put being bought as a hedge. So, it’s highly likely that the strikes will expire worthless.

Similarly, we do the same thing on the call side, selling a call and buying a higher strike call for less. If we choose similar Delta values, the premium for each call will be less, but the difference in premium may actually be more if we have the same width wings. It is a matter of preference as to whether to try to collect as much on the call side as the put side.

The risk vs reward for this set-up is the net premium difference between what was sold and what was bought and the difference between strikes. For example, if we sell a put for $1.50 and buy a put at a strike price 40 points lower for $0.70, we are risking 40 to make 0.80. Then, if our calls were sold for $1.20 and bought for $0.40, we have another 0.80 on another 35 wide spread. So in total we have 1.60, but still only 40 risk because the options can’t expire in the money on both sides. Actually, because the options are for a multiplier of 100, we risk $4000 to make $160. So, if all goes well, we make a 4% return on the capital needed in one day. Some traders sell slightly closer strikes to try to collect more premium, and others sell for less to improve probabilities.

While probabilities are fairly high that the strikes will end up out of the money, we never know for sure, so we have to protect our capital. Most traders I know use a 2x stop loss on each side. They limit their loss to twice the premium they collected on each side. So, if a put was sold for $1.50, losses are limited to $3.00 by entering a stop loss on the short put at $4.50. While a stop can be entered for the price of the spread, it isn’t recommended because during the day prices can vary in weird ways and stops can trigger on spreads when the price hasn’t really moved much. I’ve read numerous posts of traders who were frustrated by a stop that was executed when there position was in no danger because of a rogue quote. If possible, it’s best to have the stop trigger based on the bid price of the option if your broker allows it- for the same reason- to avoid bad quotes triggering a stop.

It can be frustrating when a stop triggers just as the underlying price hits the high or low of the day and reverses. A trader looks at this and thinks, “Gee, if I wouldn’t have triggered the stop, my option would have expired worthless. I took a 2x loss when I could have had a gain.” Unfortunately, a trader never knows when the price will reverse and when it will keep going. The goal is to stop our loss at 2x and not let it get to 10x or 20x. We can recover from small losses, losing all the capital of a spread trade can be devastating.

The Iron Condor is a 4 legged trade, so if one leg is stopped out, we still have three legs. On the side where the stop occurred, the long position will have gained value, although not as much as the short strike lost. We can hold the long strike in the event that price keeps moving, making the long strike more valuable. However, since the strike is likely still well out of the money, it is likely to expire worthless and probably is best to be closed out soon after the short strike stop occurs.

When we are stopped out on one side, it is even more likely that the opposite side will expire worthless. However, there is a small possibility that price action could reverse and move far enough to stop out the other side as well. For that reason, some traders will close out one side if the net premium has decayed 80 or 90% of the way while there is still a lot of time left in the day. The choice is take risk off the table, or hold out for that highly probable last 0.25%. Again, it’s personal preference.

So, let’s look at the various potential outcomes of our $1.60 Iron Condor:
1. most likely (~70%) both sides expire worthless $1.60 profit
2. sometimes (~25%) one side is stopped out and the other expires worthless ($3.00 loss on short stop, $0.20 gain on long, $0.80 profit on other side) $2.00 loss
3. rarely (~5%) both sides stopped out, assume no net gains from long strikes so $6.00 loss ($3.00 each side)
Adding all the probabilities together, we get an average return of 0.33 profit, or $33 on our $4000 capital. That’s just under 1% per day.

Can some traders do better? Yes, there are lots of variations that some traders believe give them a better advantage. But lots of traders do worse. Why? Because managing trades while sticking to a plan isn’t easy for most traders.

How can the trade be varied? Some traders enter the trade at different times in the day. They may enter at market open and again a few hours into the day. They may open on just one side based on technical indicators predicting movement in a certain direction. They may add based on one side based on market movement. They may have plans to add new positions when an old one is stopped out. Which variations work and which ones don’t? The probabilities are essentially the same but can be tweaked by collecting a little more or less in each trade.

Some may wonder why we wouldn’t just look at stopping out the whole Iron Condor when it loses twice the premium collected instead of managing each side separately. While it could be done that way, the challenge is that each of the legs of the trade are very dynamic in their values and the relationship between them changes dramatically during the course of the day. If the trade is opened early in the day, it is likely that by the final hour of the day only one position will have any meaningful value. Also, managing puts and calls separately allows traders to add and take away positions on either side independent of how they treat the other side.

On an ideal day for this trade where the market doesn’t move much after the Iron Condor position is opened, all the legs will decay proportionately and have little value left by the afternoon period a few hours before expiration. This is because expectations of the remaining move for the day will decrease and the price distance that was 1.5 times the expected move will become 3 to 4 times the remaining expected move. Since the probabilities are exponentially smaller of being tested, the premiums simply evaporate. One doesn’t have to wait to the very end to see the result.

Other days Iron Condor traders may see the price creep around moving toward one of their short strikes. Big moves early in the day can quickly lead to executing a stop, but the nerve-wracking position is the one is close to stopping out all day as the price moves ever closer to a strike price but not close enough to trigger a stop. For some traders this is stressful, for others fascinating. To avoid stress, many traders set their stops and go on about their day knowing that the market will decide whether the trade wins or loses.

Iron Fly 0 DTE trades

A completely different approach to capturing decay on expiration day is selling an Iron Butterfly or Iron Fly as it is more commonly called. The Iron Fly is created by selling an at the money call and an at the money put and buying protective wings outside the expected move of the day. The trade simulates a straddle, but defines the risk as the width of the wings to keep buying power reasonable. Most traders try to open these trades soon after the market opens and get out fairly soon, taking advantage of early morning premium decay as the market settles in.

As discussed earlier, the at the money put and call premium imply an expected move for the remainder of the life of the option. How big the expectation is varies from day to day. For example, on days when the Federal Reserve announces interest rate policy, the expected move is much higher than other days. Other anticipated news events can also trigger uncertainty about pricing changes to expect later in the day, driving premium higher. Other days, little news is expected and low premiums reflect that. So setting up this trade requires a review of prices to pick wing strikes that are appropriate.

Generally, most traders look for Iron Fly wings that are 1.5 to 2 times the implied or expected move. For example, if the total premium of the at the money put and call is $30, one might choose to buy puts and calls $50 away from the money. These should be fairly cheap compared to the at the money strikes. The idea is that there isn’t much decay left, these long options are simply protection from a sudden outsized move. An alternative is to use a set price for one or both of the longs, like $1 for the long call and buying the equidistant long put, which may cost slightly more due to pricing skew.

The most common management strategy I’ve seen for this trade is to set a win target and an offsetting stop loss, and let the odds play out. Iron Fly sellers pick either a percentage target or a dollar target for profit and typically set the stop loss at twice the win target. For example, one trader may target a profit of 5% of the premium, while another may target $1.50 profit every day. There’s logic for either approach, big values may hold value until the news event that is expected to move price, while low values may decay slowly. The key is that the bigger the target, the longer a trader is in the trade.

Why not go for it all and let the position expire? First of all, one short strike will definitely be in the money at expiration while the other short strike will be worthless. The day to day variation in results would be huge, perhaps making 50% return one day and losing 140% the next day. In addition, most studies I’ve seen on this approach suggest that this is a net losing trade over time.

The idea of getting in and getting out is that there are periods of time during the day, primarily at the open, when the level of uncertainty drops significantly in a matter of minutes or a few hours. Even with price movement, expected moves drop faster and the premium of the Iron Fly decays for a win.

In practice, the Iron Fly can tolerate a move of a few strikes up or down initially without stopping out. Early in the day the market often moves around searching for a price to stabilize on. The Iron Fly seller expects that movement to be small enough most days that a stop isn’t triggered and the settling price is close enough to the price where the trade started that the profit target can be achieved.

Setting a stop order or profit limit order is trickier with an Iron Fly than with the Iron Condor. The issue is that with the Iron Fly, a price move of the underlying generally impacts three of the four legs. One short goes into the money and the long on that side starts increasing in value, while the other short starts decreasing in value. The long on the untested side goes from low value to nearly worthless and isn’t a factor. A set and forget stop strategy would be to set a stop for the whole four legs, but triggers and fills can be inconsistent. Another approach is to watch the direction of price and set a stop for the three legs that are most impacted. Another is to set a mental stop and manually close if the price goes beyond your mental stop.

For example, let’s say we open an Iron Fly for $30 credit and target $1.50 profit. We can enter a limit buy to close order to buy the whole position back for $28.50. We could alternatively place a stop loss order at $33. Some brokers allow a bracket order that combines the two orders into one for a situation like this. If we want to watch and mentally manage the order, we may choose to only close the three legs that have meaningful value.

Time in the trade can vary from minutes to hours. Some days the price sticks right where the Iron Fly was sold and the price decays in 5-10 minutes. Other days, the price may grind away varying premium between the profit and stop targets for hours. Many traders set a time limit- if the trade doesn’t hit a stop or profit target in 2 hours, close it and move on.

Time to enter is a bit of a personal preference as well. Some traders try to enter within seconds of the market open when there is the absolute most premium available. Others wait five to fifteen minutes for the initial big move to stop. Some do just one of these trades a day, while others open several at different points in the day. Some avoid Federal Reserve days while others embrace them. There are advantages and disadvantages to each way of entering, but often it comes down to comfort of the trader with a chosen approach, the probabilities are similar.

Over time, the math is fairly simple with this trade. We need to win more than twice as often as we lose. The studies I’ve seen show this as a net winner. The other key is stay mechanical and respect identified stop values. Most people who fail at this trade do so by getting sloppy with their stops and hoping for prices to reverse while the loss multiplies. Discipline can’t be overstated.

Long Strategies for 0 DTE

Buying an option on expiration day requires a strategy that can overcome the rapid time decay of the option purchased. Since there are huge volumes being bought each day, there must be some validity to this approach.

Buy 0 DTE Straddle

One simple approach is to buy a straddle and hope for an outsized move. This is essentially the strategy discussed in the post on the 1 DTE Straddle I’ve written about separately, just done on expiration day. The difference is that at 1 DTE, there is overnight movement that may impact pricing, while once the 0 DTE trading day has started, we only have the day’s price movement to consider.

This strategy is essentially the opposite of the Iron Fly strategy and counts on movement of price to exceed time decay. Since risk is limited to the premium paid, there isn’t much value in selling wings, which would limit the upside of any move.

When would one open a 0 DTE straddle? Perhaps right at the open, looking to capture a big early morning move. Or just before a big announcement, like the Federal Reserve interest rate announcement or press conference. Or maybe at a point in the day where there is time left but the straddle is just very cheap and a small move will make it profitable.

The biggest challenge is deciding when to get out both for winning and losing positions. The position won’t expire worthless, so should there be a stop loss? When a position wins, when is the profit enough to justify the strategy over time? Since the trade has theoretical unlimited profit, shouldn’t we preserve that potential? Tough choices, so thinking through a plan ahead of time for the situation is critical.

My go-to plan is usually to roll in the money puts toward the current strike price when I can collect a significant percentage of the roll distance. Early in the day, I might roll my strikes $10 when I can collect $7. Later in the day I may do it if I can collect $8. The idea is to take some of my winnings off the table while allowing for additional movement to make more. I protect myself from a reversal wiping out my profit. I find this approach reduces the volatility of my win and loss amounts.

Jump on the Trend with a Long Option

Many traders like to use Technical Analysis to predict future movements of the market. They detect when a trend in one direction is starting and determine how long they expect it to last. A great way to take advantage is to buy a call when the market is trending up and sell it at the top before it has time to decay, or buy a put on a downtrend and sell it at the bottom.

Generally, the idea is to get in opportunistically and get out. Time is ticking against the option buyer on expiration day, so the buyer has to be right on direction and right on timing. If the trend is small or slow moving, premium will decay faster than the underlying price can increase it.

A typical strategy on an uptrend is to buy a call a few strikes out of the money. For SPX, this might cost $10 premium or $1000 for the contract. The Delta value might be 30, so that a $10 price move would net $300.

If the strike ends up in the money and is above 50 Delta, a roll to a higher strike should net at least half the distance of the roll. For example, one might roll up $10 for a $5 credit. Or wait to get further in the money where a roll up could net a higher percentage. Or just close the trade when technical analysis says that the move is approaching the top of the range.

The same basic strategy would work with puts on a downtrend. In either case, the market needs to move decidedly in the buyers favor for there to be a profit.

Time of day impacts premium pricing as well. Early in the day there is obviously more premium than late in the day. Buys earlier in the day can follow long all-day trends and make up for the high premium to get in. Late day buys can pay off quickly with a fairly small move in the direction of the trade. A trader has to be aware of the time left and manage accordingly.

The Binary Event

Often, the option premium and price movement of a day is greatly influenced by a single scheduled event. A piece of news, like an economic report, or a Federal Reserve rate announcement is often anticipated by the market with high option premium before the event and much lower premium after. These events are referred to as “binary,” in other words true or false, 1 or 0, good or bad. The impact of these events really have three outcomes for option traders- the market goes up, the market goes down, or the market basically doesn’t move. A trader doesn’t really know what the market will do, so how can we play one of these events.

A starting point might be to look at how much premium is elevated. Sometimes the market is expecting a big impact and sometimes a small one, and it often pays to be contrarian in regards to expected impact. How do we know if the premium is high or low? It takes only a few weeks of watching premium prices to grasp whether premium is higher or lower than normal, and if the high premium for a binary event is extra high, or actually a bargain. If premium is lower than normal, it might be a good time to buy options, either a straddle, or an out of the money call or put in the direction that the market is most susceptible to a big move. If premium is extra high, selling an Iron Fly or Iron Condor might make more sense.

Binary events tend to behave in crazy ways. When the initial news comes out the market may rocket in one direction for a few minutes and then reverse back to where it started or even switch from a big move in one direction to another. Most market observers explain this by noting that the very first reaction is from robot traders that look for certain numbers or words in a statement and interpret them as bullish or bearish, triggering large buys or sells. Then a combination of cooler heads prevail, as the market digests the information and puts things in context. After a while, the market decides whether to take the event as a positive, negative or neutral for the near-term future.

I know many traders avoid binary events because of the unpredictability of market behavior. There simply isn’t a built in probability advantage to any specific trade, and big losses are a distinct possibility. For traders that do like these trades, a plan for managing the trade is critical, when to get in, and a plan to hold, fold, or roll depending on the behavior of the market.

Conclusion

0 DTE trades are extremely popular now that they are available every trading day. However, that doesn’t mean that they are an easy way to make money. In many ways, they are the closest option trade to gambling that there is available. Gaining an edge requires developing and following a plan that accounts for both the potential movement of the market and decay of options. For traders that regularly trade 0 DTE options, it is critical to track all trades to make sure that the strategies used actually average a positive return over time.

I’m actually not a big fan of 0 DTE. For me it is too much drama with too little edge. The rest of this site is dedicated to other strategies that I prefer. But for traders that have the wits and discipline to trade 0 DTE, all I can say is “best wishes!”

2022 Learnings

In 2022 I had a rough year in many ways, but also had many successes, and need to take away some lessons from it.

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

Overview

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

What didn’t work and why

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

Short duration trades

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

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

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

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

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

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

Selling Calls too Close to the Money

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

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

Selling Options on Individual Stocks

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

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

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

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

What went well

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

Selling Long Duration Puts

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

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

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

Put Ratio Trades

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

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

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

Using Futures Options to Pump Up Returns

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

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

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

Selling Naked Futures Options

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

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

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

Using Research to Test Strategies

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

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

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

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

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

Buy 1 DTE Straddle

I buy a 1 DTE straddle on indexes for two reasons. 1, It has a positive expectancy over time. 2. It is a hedge against short option positions

I’ve started buying 1 DTE straddles on the S&P 500 for two reasons. First, this straddle trade has a positive expectancy- over time it has made more than it has lost. Second, and perhaps more importantly, the straddle is a great hedge against my many short option positions further out in time. How I came to these observations and how I manage this trade are the topics of this discussion.

A straddle is buying a call and a put at the same strike price and same expiration. When traded at the money, it roughly represents the expected move of the underlying for that time period. So, buying a 1 DTE straddle for $30 would mean that the market expects the SPX index to move around $30 plus or minus the next day. Buying a straddle means the buyer is hoping the market will move more than expected, and the seller is hoping the market will move less than expected.

Normally, I only sell options or spreads for a net credit and wait for the value to decay away for a profit. I mostly sell options with expiration dates weeks or even months out and a decent distance out of the money. Those trades have a high probability of profit. However, they also carry the risk that an extended big move in the market could result in a big loss.

Profiting from the trade outright

With 2022 being a bear market year, I have studied more about ways to manage positions in downturns. One interesting book on the topic is “The Second Leg Down: Strategies for Profitting after a Market Sell-Off” by Hari P. Krishnan. One observation in the book is that options under 7 DTE tend to be undervalued and have good potential to make money or protect a portfolio in the midst of a downturn. The book has numerous interesting strategies to help navigate downturns. I’ve toyed with a few of these, but I couldn’t find a trade strategy that achieved the type of positive outcome I was looking for.

As I’ve noted elsewhere, I’m a big fan of the TastyLive.com broadcast site. Just before Christmas at the end of 2022, Jermal Chandler interviewed Dr. Russell Rhoads on his Engineering the Trade show. The topic was short duration options that are now quite prevalent. One key point is how very short duration at the money (ATM) straddles on SPX (S&P 500 Index) and NDX (Nasdaq 100 Index) are actually underpriced. If you buy a 1 DTE straddle at the end of the day and hold to expiration the next, it has averaged a positive return in the past year, which says these options are actually undervalued, counter to what we would normally expect.

I’ve added the presentation, which is broad ranging on the topic here:
(Press the red play button to watch)

Starting at about 8:00 into this video, the discussion starts on how 1 DTE premium has been underpriced for the past year.

I decided to try buying these as a one lot and so far I’m seeing this work out with a positive return. And this has been during a few mild weeks with little movement. The straddle never expires worthless as one side is always in the money- it’s just a matter of how much. I have generally closed these early, selling the side that is in the money when I can for more than I paid for the straddle. So far, this has worked better than holding to expiration because we have been range-bound. When we get into a trending market one way or the other, it will likely make more sense to hold.

The hedging benefit

However, I found a second benefit that may be much bigger. I decided to switch over and buy a 1 DTE /ES (S&P 500 mini futures) option straddle in an account with a lot of short futures options for a 1 DTE straddle- not sure why I even decided to other than the size is half as much. Anyway, I noticed that buying one straddle greatly increased my buying power by over $27K, which didn’t make sense initially because I was paying a debit and I thought that would reduce buying power by what I paid-about $1500 ($30 x 50 multiplier).

It turns out that the futures SPAN margin saw this as a big risk reduction. (For more on futures options and margin, see the webpage on different option underlyings.) Buying the /ES straddle gives me 500 equivalent shares of SPY notional in either direction of price movement. This will counter several short options out in time and out of the money. So essentially it is a shock absorber for my futures positions.

Many traders are nervous about the overnight risk of holding short options, due the possibility of a big gap in price overnight. Having a hedge like this can help mitigate that risk.

The biggest question is how big of a position is appropriate? Well, keep in mind that if the market doesn’t move at all and closes very close to the strikes of the straddle, the straddle will be nearly a complete loss. So the size of the trade should be a very small portion of a portfolio, as this trade will be very volatile, going from losing nearly 100% some days to returning several multiples of the initial value others. Think of it as a volatile side trade that can reduce volatility of a much larger set of positions. Kind of a contradiction.

Futures make this obvious, but the same logic applies to any portfolio full of short option premium. The S&P 500 and Nasdaq 100 indexes have a variety of options underlyings at different costs to allow traders of virtually all account sizes to utilize this kind of trading strategy.

So, I think there are a number of angles to pursue this from a trading and portfolio management tool. I thought it might make a good topic to discuss with this group- the gamma of this trade provides a lot of protection at a low cost, essentially free over time, although likely to have periods of loss.

Essentially, I look at it as a great hedge that can still make money on its own. If I have out of the money longer-dated short options in a portfolio, they will make money on calm days, and the 1 DTE straddle will make money on turbulent days. And if I manage each correctly, each should make money over time.

Managing the Straddle

I tend to buy these straddles right at the close the day before expiration. On Fridays, I buy Monday’s expiration, which surprisingly often is about the same price as other days. I’ve tried buying two days out and laddering, but that gets to be a lot to keep track of if I try to manage early, so I prefer to buy at the money at the close for just one day.

Like all option trades, there’s always a management choice of hold, fold, or roll. This trade has all those elements to choose from.

As mentioned earlier, probably the simplest choice is to just hold to expiration. The odds are that over time, the trade will win more than lose. However, this may mean that we have a day where a trade is profitable at some point in the day, but then moves back toward the strike price and loses money. Finding a way to beat simple holding takes a lot of effort and since we know the worst case scenario is losing all the premium we paid, we may want to just let it ride. On days where the market is on the move, this can be very lucrative, as the max move may be at the close of the day. Think of holding as the default way to manage the long straddle.

I’ve found that calm days in a range-bound environment are ones where prices explore support and resistance levels before returning to a point closer the strike price. As the day goes on and price stays constrained, I look for a chance to sell one side of the straddle for a price more than I paid for the total. Earlier in the day, I feel like I can be greedy and wait for a big profit, but as the day goes on, I’m happy to get out for any profit. So, I’ll fold one side of the straddle for a profit when it doesn’t look like we are going to close at an extreme move. Occasionally, I might get to sell the other side if there is a late move in price to the other side of the strike price.

So, that’s hold and fold. How/why would I roll? Let’s say the market has moved a significant amount from the strike price, and I’d like to take a profit but still have the possibility of taking advantage of additional movement. I can roll my in the money option toward the current price for most of the distance rolled. For example, let’s say the price of SPX is down 40 points midway through the day and I’m worried it might come back up, but want to also benefit if it keeps going down. I could roll down my put 20 points and maybe collect $18, locking in 90% of the move. If the price keeps moving, I could keep rolling. The downside of this is that I don’t get 100% of the move, and I’m paying commissions on each roll, and these trades will be pattern day trades if I close the new position before the end of the day. I also will have a hard time locking into a profit that is beyond my purchase price, unless I have a really big move. But rolling is a choice to consider for some traders and some accounts.

Conclusion

So, there you have it. A volatile option buying strategy one day before expiration that averages a profit and can hedge other positions in a portfolio. I have found expiration trades stressful in the past, but this one has been much less stressful to me despite the volatile nature of it.

The August 5, 2024 VIX Explosion Impact

Personal Impact

The Perfect Storm of Fear

Unprecedented Changes in Implied Volatility

Margin impacts

Marked loss impacts

Position size considerations and notional value

Impact of the number of net naked options

Defined risk vs. Naked Risk

When the tide goes out, you find out who is swimming naked.

One time event, or regular occurrence?

(Without losing a lot of Theta decay)

Covered Call Trades

Stock Replacement Call Trades

Poor Man’s Covered Call Trades

Buying an Out of the Money Call Spread

The Call Back Ratio

Conclusion

Call Spread Set Up

Managing the Out of the Money Call Spread

Holding a Call Spread to Expiration

Folding with Limits

Continually rolling a credit spread

Why this Delta range works

Assignment Risk

Final Thoughts

Managing the Poor Man’s Covered Call

Managing Big Moves

Overall considerations

Trade Sizing: Leverage and Risk

Assignment Risk

Final Thoughts

Changing to a full time “real” job

My new routine

Results

Probabilities, Volatility and Manageability

Probabilities of Profit

Portfolio Volatility Reduction

Managing Strangles

Level 0 Strangle?

Things to know about 0 DTE

Selling options with 0 DTE

0 DTE Iron Condor

Iron Fly 0 DTE trades

Long Strategies for 0 DTE

Buy 0 DTE Straddle

Jump on the Trend with a Long Option

The Binary Event

Conclusion

Overview

What didn’t work and why

Short duration trades

Selling Calls too Close to the Money

Selling Options on Individual Stocks

What went well

Selling Long Duration Puts

Put Ratio Trades

Using Futures Options to Pump Up Returns

Selling Naked Futures Options

Using Research to Test Strategies

Profiting from the trade outright

The hedging benefit

Managing the Straddle

Conclusion

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