Merry Christmas everyone! I hope this holiday season is just as merry and bright as the song suggests. Personally, this has been a heavy Christmas. So many things going on in not only my life but also my families lives and navigating the different challenges is certainly having an impact. Still, it’s this time of year when we remember, God sent His only Son into the world. We know, He did not come to condemn the world but to save it. So, no matter where life has you today I hope we all remember to look up, bow down, and believe!
That said, I’ve been doing a great deal of soul searching recently. I’m not exactly loving my job anymore and for reasons I won’t bore you with I’ve decided I want to make a change. At 41 years old I probably shouldn’t be considering this but as the old saying goes, “when you know, you know”. So, I’ve started putting in applications to other opportunities and we’ll see what happens next.
In the meantime, I’ve also been looking at the possibility of earning a living trading options. Is that even possible? Where would I start? If earning a living trading options were easy, wouldn’t I already be doing just that? Can we really “count on” the market to remain sustainable?
All of these questions are crossing my mind as I think about what comes next. So, in today’s post I want to briefly consider the viability of earning a living trading options. Let’s get into it.
Post Agenda
Earning a Living Trading Options Strategy Considerations
The very first thing, I think, is to determine what strategy could accomplish this task. Knowing, of course, that too little means the bills aren’t paid, and too much comes with devastating levels of risk. The questions here are really insurmountable. The very nature of options are the seemingly endless number of ways they can be traded. So, I guess the best way to approach the strategy conundrum is the same way we approach anything. Stick with what you know and keep it as simple as possible.
Fortunately, I’ve been trading and studying options for years so I have formulated a list of strategies I prefer. If you’re interested, you can check them out in this post, “My Top 5 Options Strategies”. However, if you don’t wish to view, I can sum them up easily enough as a group of low risk income or protection focused strategies. Possibly the best approach to earning a living trading options is to combine them all.
Therefore, here are the strategies I’ll consider using;
- Options Collar
- Poor Man’s Covered Call/Put
- Options Wheel
- Put Ratio Spread
The collar will serve as the foundational piece where risk is the lowest and returns can be higher than the risk free rate. From there, a portion of available capital will be allocated to generate income with the PMCC/P strategy. This gives me the greatest level of “income” relative to cost. Similarly, to further enhance income the wheel strategy would also be used. Meaning, a larger amount of capital but I don’t have quite the exposure to long decaying options. Finally, the put ratio spread would provide black swan protection against catastrophe.
How Much is Enough
This will be different for everyone but for me, I’d feel comfortable if I were able to replace my current level of income. Thus, some assumptions will be required. As a brief aside, making an assumption here kind of feels like building a house on quick sand. In any case, for the sake of discussion let’s assume I need $5,000 per month. This pays the bills, the taxes, and gives a small buffer for unforeseen expenses, or dare I say, savings.
To be truly accurate here, I’d need to run my complete budget requirement. I need to tally up every conceivable expense. Mortgage, insurance, car payment, electric, water, entertainment, groceries, etc. Quite literally every single detail of my financial life would need to be written down and assessed. However, for the sake of time I won’t do that here. Instead, I’ll move forward targeting $5,000 per month.
Once I’ve decided how much would be enough I can then begin making the real assumption. How much capital is needed to achieve this number. Sustainably.
Again, for the sake of discussion, let’s assume these targets;
- Options Collar – 2% per month
- Poor Man’s Strategy – 5% per month
- Wheel Strategy – 1% per month
- Put Ratio Spread – (1%) per month
Assuming these percentages are possible, the put ratio becomes a drag but that’s to be expected. The put ratio is simply the safety net if everything else goes up in smoke. Still, this hypothetically creates 7% in income per month. If I do some quick math and divide $5,000 by 7% I get a number around $71,000. Not to bad and with more capital the percentages could be even lower. Still this assumes every dollar will be working around the clock which may or may not be realistic.
Building a Safety Net
I realize I’ve already pointed out what strategy I’d use as a safety net but there’s more to consider. I think of it like taking out an umbrella insurance policy for a business. If I’m an electrician and my wiring job burns a house down, will my insurance step in to cover that cost?
So, to build a true safety net I’d need to consider how much capital is being deployed? How much can I spend to remain under my 1% target? How far does the market need to fall for the insurance to “kick in”?
Using just the barebones numbers calculated in the previous section, I know approximately $71,000 of capital will be working. A real safety net would need to protect all of this. However, that’s probably not realistic if I want to keep the cost of this net under 1%. In this scenario, I’d have about $700 per month available for insurance costs.
Using historical options data I could potentially remain under my $700 monthly cost if I move about 25% below the current price. To say that another way, protection wouldn’t really “kick in” until we see a 25% fall. The trade would offer some benefit up to that point but the real meat of the put ratio spread wouldn’t pay out until we see a precipitous decline.
That said, a slow grind bear market would leave me in a precarious position. Without a fast fall, the insurance wouldn’t provide the same level of benefit. It would still help but the put ratio strategy is built with options and therefore decaying from the minute the trade is placed.
Putting it All Together
Now for the fun part. Testing this approach against historical data. Before I do, let me quickly provide some metrics for the test based on the information provided above.
- $75,000 Account Balance ($18,750 per strategy)
- 7% or $5,000 per month of income
- 1% per month for protection
With this I will test the viability of earning a living trading options for just one month. I won’t go overly granular here, like I would if I were trying this for real. Instead, I’ll just deploy an equal amount to each strategy while targeting the 7% figure.
Options Collar
- Buy 300 shares of MO at $55.47 per share or $16,641
- Buy +3 Long puts at $55 strike
- Sell -3 Short puts at $60 call
This gives me an upside profit target of $1,359, a $153 dollar credit, and a dividend payment of $306. If all goes according to plan that’s a total of $1,818. Of course, we know it won’t work out perfectly but this provides the opportunity of 1/3 of my monthly goal in a very low risk trade.
Poor Man’s Covered Call
Depending on if my directional assumption was more bullish or bearish would alter this trade. If I were bearish, I’d use the poor man’s covered put. However, in this case, having done no research I’ll just stick with the poor man’s covered call on SPY.
- Buy 7 long calls of SPY at $22.20 per contract
- Sell 7 short calls of SPY at $4.20 per contract
That gives me a total of $2940 of income with an upside profit target of about $5,400. If all worked perfectly, that’s more than the monthly requirement with 1 trade. If it doesn’t, I at least keep the $2,940 now and review my NAV erosion at the months end.
Wheel Strategy
Similar to the collar strategy above, I’ll prefer targeting a dividend stock. However, I also have to keep in mind there is a strong possibility I own these shares for a while. In that case, I think Nike (NKE) is a good fit. I like the company, it pays a modest dividend, and the premiums are attractive. Additionally, whenever I’m in cash secured puts only I can park the capital into SGOV to earn a small return there as well.
- Sell 3 ATM puts of NKE at the $74 strike for $3.55 per contract
- Buy 220 shares of SGOV
This yields me $1,065 in premium on the cash secured puts along with $90 in income from SGOV. A total of $1,155 toward my $5k goal for the month. There really is no perfect move here. If price rallies, I’ll just sell more puts. If price falls, I’ll take the shares and sell calls at whatever level meets my income need. Hopefully above my cost basis but if I’m earning a living from trading options I’ll have to take whatever comes.
Put Ratio Spread
Finally, I need to get some insurance on the books. My monthly assumption was around $700 per month but in truth, the best way to allocate here is to add up the guaranteed income I have from my trades. In that case, I have $459 from the collar trade, $2,940 from the PMCC, and $1,155 from the wheel strategy. All totaled that’s a guaranteed inflow of $4,554 with considerable upside or downside potential. I’m just shy of my $5,000 goal but given the risk and potential for appreciation this gets me close enough. Now, with the income totaled I know I need to scale down that $700 to something closer to $600.
- Sell 3 Short puts at the $560 strike
- Buy 6 Long puts at the $555 strike
The total cost per spread is $1.99 or $199. A total of 3 spreads equals $597 dollars with an unlimited upside if price falls fast. If price slowly falls, this trade won’t provide the desired protection, nothing will. Still, if the sky falls I’ll be glad to have it.
Final thoughts
If I add everything up and calculate for upside targets here is the possibility for the month;
- Options Collar
- Guaranteed income – $459
- Upside potential – $1,818
- Poor Man’s Covered Call
- Guaranteed Income – $2,940
- Upside potential – $5,400
- Wheel Strategy
- Guaranteed Income – $1,155
- Upside Potential – Unknown until calls are sold
- Put Ratio Spread
- Guaranteed Income – none
- Upside Potential – Up to $17,700 if price falls 15%
This gives me total guaranteed income of $3,957 including the $597 cost for the ratio spread. If I add in the upside potential there is a slim chance I make up to $7,776 this month alone. That’s a fairly serious variance but for fun, I plugged these trades into the back test machine and here are the results at the end of the month.
Position Review
The total P/L for the month was 3,007. Here’s the position breakdown;
- MO traded lower but the short call and long put were both profitable. I kept the $459 of income along with $268 from the long puts. A total of $727 of income on this trade. My NAV declined $639 though so mostly a wash overall.
- NKE traded higher so I kept the entire premium from the short puts. A total of $1,155 of income.
- SPY put ratio spread expired worthless. A cost of $597 against my income.
- SPY PMCC was stellar. I kept the $2940 of income and only lost $87 from my long calls.
All together that comes to $4138 in income with the only real hit to my principal coming from MO. I started with $75,000 and assuming I withdraw all the income I’m left with $74361 to setup my goal for next month. Lastly to add perspective here, when I entered each of these trades SPY was trading at $590.50. When I closed these trades SPY was at $588.75. The high for the month was $609.07. Meaning, if I had managed this portfolio I may have made my $5,000 dollar goal well before the end of the month.
Until the next post you may also want to join the discussion at Reddit, “Can one truly live off of Just Options Trading?”.
God bless,
Jeff
