A Perspective from an Options Trader

Disclaimer: please understand that options trading is complex and you should only pursue the activity after learning about the process yourself. This article is here to provide a different perspective on investing. It is not a recommendation for you to start options trading.

You say “bull put spread” and I say WTF? You too? Well, I’ve got a good one for you guys today. @blerghhh has been kind enough to bestow us with some excellent and controversial investment advice. Ever since we crossed paths on the internetz, I’ve been fascinated with @blerghhh’s investment style. His is very, very different from the standard stuff all of us personal finance bloggers spout day in, day out. To the uninitiated, this style seems controversial, complex, and dangerous. I laugh in the face of danger. Come check it out.


Mainly due to my own ignorance, I don’t yet 100% understand @blerghhh‘s method of making money in the stock market. Again, mainly due to my own ignorance, I probably would not employ this style myself. But @blerghhh shows how employing a profitable options trading strategy can be a very financially savvy play. Take it away @blerghhh!

A CRASH COURSE IN OPTIONS TRADING

There was a time in my life when I was full of youthful enthusiasm, zeal, passion for my craft and world-domination. If that’s you, don’t bother reading this. However, if you’re sick of the rat-race, want to spend more time with your family, have a few thousand saved up, can keep your life-costs down then I have an investing strategy for you.

If you think the stock market is gambling, than read no further. I have no interest in attempting to convert the closed minded. But if you are interested in a way to make incremental gains with highly controlled risk, without much volatility then you might want to pull up a chair.

I’m going to assume you’ve heard of the stock market, but you may not have heard of the options market. It’s where people trade contracts that represent the potential purchase or sale of the underlying stock market.

I won’t delve into the explanation much further than that because I can already hear the heads rolling.  It’s really not that complicated, but it is a mind-job at first. Just do yourself a favour and don’t ever ask who or why is on the other end of your trade. (With thousands of traders, banks, insurance companies, etc. they all have different strategies and will be trying to do something else. So it doesn’t concern you. Save time and don’t ask)

My primary trading “thing” is called a “bull put spread”.  It can go by other names like Vertical Spread or some such.  But it can be dumbed down by saying it works like insurance. I’m insuring somebody’s stock price and hedging that by insuring my move by buying some of the same with a slightly lower face value. Hence the “spread”, which is the difference between the face value of my 2 positions.  (face value = strike price).  The biggest plus is that because your absolutely worst case is defined, the capital requirements to cover this move are very low, so you can collect the gains from hundreds or thousands of shares even if you could never afford to buy hundreds or thousands of shares.

As insurance has premiums, I collect premiums from the person I’m insuring and give premiums to the person insuring me.  I’m on the hook for the difference between the two, but at the same time that’s my absolute drop-dead loss if I decide the play isn’t working out (because the underlying company has gone wrong).  Otherwise, you can postpone your move by trading it to a similar move with a longer expiry.  (Think “term” based on my insurance analogy)

So if things all go to plan then I keep the difference, which happens more often than not, provided you choose your entry wisely.  Picking an entry depends on what company you want to do this on.  I generally stick to big, boring, blue-chip stocks that are by all means bellwether friends and aren’t exactly the type a young, money-hungry, get-rich-quick-scheme desiring 20-something wants.

For an example, Apple Computers was one of the first spreads I publicly tweeted as a live-tweet trade (yes yes, I know it’s not a typical blue chip, but it’s huge and sells a LOT of phones), was on August 1st.  Apple was Trading around $95-96 per share.  I opened a bull-put-spread for 5 contracts (5 lots of 100 shares) $85/80 with a January 1st 2015 expiry.  (Selling $85 puts and buying $80 puts.)  I collected $1.08 (per share) for a total of $540 – commissions.

Now, the fun bit:  Come January
1. if Apple goes up, I win
2. if Apple stays at $96, I win
3. if Apple falls but doesn’t go below $85 I win
4. If Apple falls to $84, I break even
5. If apple goes bust, I lose $500 (the spread) MINUS the collected premium $108 per contract of 100 shares.

However, there is a way to extend this thing by “rolling” the position into a new one, which would provide more time for apple to recover. (If that were the case).  I picked Apple because I didn’t see it falling 12% or more in 6 months.  Now that it’s gone up, it would have to fall 15% for my position to lose money.

Now the juicy bit:

5 contracts $500 spread = $2500
$1.08/s * 500 shares = $540 premium collected.
So a $540 potential max gain on $1960 max loss (2500-560) is a 27.5% gain in 5 months,  which represents an annualized yield of over 50%.

How is this trade doing now, now that it’s October?  Apple has gone up in value $10.  Thus the premiums on my position have decreased.  (Which is exactly what you want to happen).  So I could close now  (after 7 weeks) to capture 50% of it’s max gain.  So this represents an even crazier annualized yield.  Why not close it?  Commissions.  It’s only 1/2 way done.  I’ll let it go to collect the full amount.  I don’t need to trade trade trade all the time.

Now this example is one of the juiciest trades I’ve done lately.  My typical targets are about 1/2 or 2/3s this much.  I just like Apple, and the premiums were very compelling.

Summary: Why do I like this?

Low volatility.  Your positions can survive considerable market/stock price drops.
Low capital requirements.  You don’t need a lot of money to do this
Low risk. By doing this on a broad basket of stocks you eliminate sector and company risk, AND if necessary you can “roll” your troubles away.
predictable and steady gains

Cons:

You won’t get rich quick
It does take some capital…  My apple trade example requires $2500 of cash in the account for 5 months to make $540.
You can only do this in a taxable brokerage account, and nearly every broker in Canada charges crazy high fees for this sort of thing.  Interactive Brokers is the best choice for this type of trade as their costs are less than 1/4 of what everybody else will charge.

Conservatively a 20% return is not difficult doing this, even on big blue-chip companies.  You can even make 10-15% annually on positions that have enough wiggle room to survive market corrections of 30%

Update since writing: I also had a position I opened 1 month later for a similar spread on Apple.  It was with a December expiry.  I just closed it yesterday (position open for 28 days) after it had captured 80% of the maximum premium.  Since I closed early, this represents an 80% annualized return.

I’m @blerghhh and I live-tweet my trades @short_put

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22 thoughts on “A Perspective from an Options Trader

  1. Great feature, Steve! I knew very little about options and never really understood it until I started talking to @blerghhh back in August. He has totally open my eyes to a whole new income stream. I have embraced his methods and it works! Of course, there are some risks if the market crashes. Just have to manage it all. There’s a lot of wealth to this post… for those who choose to learn, they will be rewarded with this investing style. Of course, this is not everyone’s cup of tea.

    Have you decided on making the switch for your job yet, Steve? Would like to see a follow up post 🙂

    1. A follow up post on the job will come probably late-November or December!

      I think there is a lot of potential in trading options – I know nothing about it though so would not try the strategy until I learned more about it. Blerghhh’s post was excellent intro material on how to use options trading strategy effectively.

  2. I should have also mentioned the whole point of these spreads is to complete cover your maximum loss. If you buy a stock or ETF, you NEED it to go UP and/or pay a dividend. If it goes sideways without paying a dividend you make nothing. If it goes down you lose. If it goes belly-up, you lose everything.

    With a spread, you will never be “the bag holder” if all hell breaks loose. Your ETF or stock? Not so much.

  3. And no, I’m not rolling my eyes. Making the leap to the options market is a difficult one for the novice. It will make your head spin. You will lose sleep. You will wake up in the middle of the night saying “AH HA! I GET IT!” Then you will wake up in the morning and be just as confused as before.

    Once you do get it, you’ll almost immediately say to yourself, “why don’t more people do this?!? It’s so easy!”

    Thanks PC for the commentary. Hopefully Steve, your readers (and you too eventually) will take a look at this technique. Which is completely not controversial. (Just because you don’t understand something doesn’t make it a controversy!)

    It’s only complicated if you don’t understand options. Once you do, it really is a cake-walk.

    1. I don’t want to wake up in the night saying “ah ha I get it!” then wake up and be even more confused 😉

      I seriously will look into the bull put spread strategy you so kindly introduced here. It might take a year or two before I am ready to commit to trying some of this stuff out with smaller amounts.

      I don’t think it’s controversial at all – I just think that because of its inherent complexity for the novice, it might be mistakenly seen as controversial!

  4. Interesting strategy. Did you experiment with it yourself when you first started or did you pick it up from a book? If so, I’d be interested in reading more about the concept.

    1. I did experiment (and continue to) with many strategies.

      But I arrived at this one because it’s the easiest to stomach. The risks are amazingly well controlled and the volatility is super low. Plus, it makes money 80% of the time without having to do anything.

  5. I’ve been reading some books on option trading but things just get a bit confusing to me. What you wrote above is very interesting, need to look into it more.

    1. It’s a HUGE mind-job at first. Give it the time it needs.

      And don’t be afraid to ask me questions @blerghhh on twitter.

    1. I do this because I don’t have a lot of capital to work with.

      Plus if you buy a dividend stock you need it to go up or go sideways and you need it to NOT cut the dividend.

      My way: I can make a move on the same dividend stocks you like, but they can go up, they can go sideways, and they can even go down somewhat and I’m making money and not losing sleep.

    1. Taxes = yes. It’s a capital gain. But as I’m a stay-at-home trader so it’s 1/2 of what I would pay if I were working a 9-5 job for the same money. (based on the tax rules in Canada on capital gains)

      As for the risk: if you buy a stock or ETF, EVERY DOLLAR you spent is on the line. For me? Only the spread. Plus, if it’s a broad-market recession, I can roll the position and roll it again and again and again until it goes to the good as things recover.

      And as for gains, my realized profit is much higher than 20%. I seldom say what it is because people don’t believe me. (Mostly because they don’t understand the power of the options market).

      1. I’d be interested to see where this conversation goes if it develops any further – Henry? I think blerghhh makes a point that when one owns common stocks, one is theoretically/technically at risk of total loss if the company busts.

  6. Interesting…

    My strategy has always been the opposite of this; buy and hold stocks forever. My oldest holding is Google which I’ve held for almost exactly 25% of my life (10 years). The folks that I know who have played with options always seem to have horror stories, so I avoided them and didn’t bother to learn. However, you’ve piqued my interest. Thanks for the writeup!

    1. Ask me anything about it on twitter. It’s a mind-job at first so do not be afraid to ask any question you want. You will have an “ah-ha!” moment as you lay in bed trying to sleep. But then the next morning, you’ll be even more confused than you ever were before. It took my mind a few weeks for it to sink in and for me to get comfortable.

      Run your numbers through this online calculator: http://www.optionsprofitcalculator.com/calculator/put-spread.html

      It will show you how your spread will perform over time and show you your max loss and max gain for the entire duration of the contract.

      NB: most brokerages charge criminally high fees. Any broker that has a flat-fee PLUS a per-contract fee is too expensive. Interactive Brokers does NOT charge a “per-trade + ” fee. They just charge per contract. Typically it’s no more than $0.79 per. The lowest I’ve paid was $0.055 per contract. A small trade of 2 contracts (1 spread) which cost me a whopping $0.11 commission.

      Again, do NOT be afraid to ask me ANYTHING about this.

      The hardest part for novice option traders to understand is the concept of the “roll” which, provided the underlying company is still solvent, lets you work your way out of the trade over time. But that is the topic of an equally lengthy post just like the one I just wrote.

      1. Hey, thanks a lot! I’m exhausted at the moment, so am going to throw this one on the whiteboard and work through some problems so I can truly get my mind wrapped around it. Thanks so much for the offer to help!

        Oh, and I have considered covered calls before to exit some positions, but haven’t actually done that either.

        1. Covered calls are a great place to start and an excellent way to trim or exit a position. Or with a bit of luck, you keep the premium AND keep your position if the strike price is never hit.

          Short puts (naked or cash covered) are the easier side of the board to understand. SELLING a put is essentially agreeing to BUY the stock at the strike price. If the terms are NOT met at expiry, you keep the premium and walk away.

          Just make a note to yourself though: find out what your brokerage charges as the “assignment fee” or “option exercise” fee. It’s surprisingly expensive at some brokerages. (Interactive Brokers does it for FREE)

          1. Darn! Here I was, thinking I could open a margin account at TD Direct Investing and give this a try. Then I read the fees and commissions schedule.

            You’re right, this is really expensive.

  7. LOVE LOVE trading options but I have never done a bull put spread only the odd call spread – and they all worked out well. (probably more luck that savvy investing though.) I have also taken the odd gamble – and thats can be a problem! Great article.

    1. Thanks! I’m glad more than a couple experienced option traders are finally chiming in. It lends some cred, and helps those who have yet to discover the options market leart that what I’m doing is real, is possible, and is frighteningly easy.

      Today I closed a spread (which I even blogged about) that made me a paltry 6% gain in 78 days. Which is annualized to 28%. Which according to my play-book isn’t all that fantastic.

      On the more outrageous side, I entered a spread on GOOGL last week (live tweeted on friday the 24) and it had already moved to 57% capture. I didn’t close it yet, but if I had, that would have represented an annualized yield of over 420%. (The position has only been open 1 week)

  8. Hey there,

    I found this post, I know it was from 2 years ago. You are definitely right. There are times I get the concept and there are times I don’t.

    It looks like using TD Direct Investing is the worst way to employ this strategy. It doesn’t allow you to execute a Vertical Trade as a single transaction/action. Does Interactive Brokers allow you to do it with one click?

    How much capital do you recommend to get started on using a Vertical Spread strategy?

    On average, how much would Interactive Broker charge to execute a Vertical Spread trade?

    Thank you so much.

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