I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Monday Money, I write about money management.
I’m really enjoying my new approach to managing my income portfolio, the options wheel. With the options wheel, you sell puts on stocks or ETFs that you wouldn’t mind owning for a premium. If the stock goes up, or at the very least stays above your strike price, you keep the premium. If the stock happens to hit or go below your strike price, you get assigned the stock to purchase (in lots of 100 shares).
If you do get assigned some stock — let’s say Microsoft, on which I sold a put before the recent price declines, meaning I may have to “take assignment” — then the second part of the wheel is selling calls on that stock. Calls give someone else the right to buy a stock at a certain price and result in an obligation on the part of the call seller to sell the stock at the strike price. If the stock price doesn’t reach the strike, you keep the premium. If it goes to or above the strike, you sell your shares.
This is the wheel — selling puts for premiums and occasionally getting assigned (most wheelers try to avoid that through various means) and then selling calls until the shares you purchased are called away.
The problem with the wheel is that you have high tail risk — the risk of a bad thing happening leaving you with very large losses, far bigger than what you regularly earn from selling puts and calls.
Managing risk with short puts and short calls
This week, I’m going to start using bull put spreads instead of simple one-leg short puts. This options trading approach pairs short puts with long puts (at a lower strike) to reduce the probability of assignment. You can still get assigned with a bull put spread but it’s very unlikely especially if you manage the spread well — closing it out before expiration for example if the underlying stock price is below the short put strike.
If individual stocks on which you have sold puts decline significantly below the strike price of your put, you end up with a big loss when you purchase that stock. That’s a potential outcome you want to avoid.
More important is when almost everything declines at once, as in a market correction or crash. You can get assigned on all your short puts at prices far below your strike prices and see all your recent options profits wiped out. The options wheel isn’t any better than holding long stocks during a down market.
With bull put spreads you can still lose money, but you cut off the possibility of losing more than you’re willing to lose. The bull put spread is constructed so that it produces a maximum profit and a maximum loss. With an approach to selling at certain profits or losses you can control this even further.
Buy and hold suffers from the same “tail risk” that the wheel suffers from
Tail risk refers to “rare but extreme investment outcomes that occur more frequently than traditional risk models assume.” These kind of risks can decimate a portfolio.
Financial instrument outcomes are not generally distributed normally (i.e., according to a gaussian distribution), so outcomes that would be extremely rare for something normally distributed, such as a three-sigma move, can happen with some frequency. Check out, for example, Micron’s recent parabolic move upwards.
After the dotcom bubble burst in March of 2000, the Nasdaq Composite index declined by more than 80% and the S&P 500 by 50%. This is a risk you want to be ready for. While many people will tell you that “this time is different” and the wild stock runups we’re seeing in semiconductor stocks (and before that the hyperscalers) represent a rerating for a new, more productive, more economically bountiful age, your portfolio could suffer terribly if you just leave it fully invested in stocks in case of a big and long-lasting downturn.
Intellectual insecurity
My natural bearishness–i.e., my constant questioning of what bad things might happen–is a benefit to my options trading where it has been a hindrance when I tried to follow conventional investing wisdom. I could too easily see tail risk to remain invested at all times. With bull put spreads, and other kinds of more advanced options trades, I can explicitly manage and account for tail risk.
In Fooled by Randomness, Nassim Nicholas Taleb writes that my natural skepticism about whether everything’s going to be ok is of personal benefit:
I believe that the principal asset I need to protect and cultivate is my deep-seated intellectual insecurity. My motto is, “my principal activity is to tease those who take themselves and the quality of their knowledge too seriously.” Cultivating such insecurity in place of intellectual confidence may be a strange aim—and one that is not easy to implement. To do so we need to purge our minds of the recent tradition of intellectual certainties…. It certainly takes bravery to remain skeptical; it takes inordinate courate to introspect, to confront oneself, to accept one’s limitations—scientists are seeing more and more evidence that we are specifically designed by mother nature to fool ourselves.
Reading Twitter, as I do regularly (calling it “twerting” when I only lurk but do not post), you see many people certain of their positions. You can know how they are invested by what position they defend staunchly and repeatedly.
That will never be me, and it has hurt me in the past that I couldn’t get on past market bandwagons without asking myself, “what if this changes?” I hope that I’m finally finding a way to profit from my intellectual insecurity and skepticism.