If you are like most investors, your goals are to make money, to grow your capital or to generate income.
These are all worthy objectives.
What you may not focus on is how to obtain these goals. If you are like most people you want to make money with the lowest possible risk, stress and drawdowns while still maximizing consistency. But you won’t say that because we all know that any investment, including selling options, involves risk. And to acknowledge fear is often against the “comes with the territory” bravado common to alternative investors.
As a money manager and broker, I am the biggest coward in the world when it comes to putting client equity at risk. I hate risk; I hate stress; I absolutely hate drawdowns; and I am constantly looking to improve consistency. Fortunately, selling options has built-in consistency that already can give you a big percentage of winners for every loser. What likely can make your option writing portfolio a more prized allocation however, can be a smooth equity curve.
Generating a great return can be tremendously gratifying. However, if you are like me, it may not be worth the trouble if you have to ride a roller coaster to get there. You’re investing for return, not excitement. Double-digit returns may be what you are after, but getting there in a smooth, reliable unward trend is preferable to wild monthly swings, dips and recoveries.
To that end, one key element to incorporate into a strategy is not only diversifying the markets in which portfolios sell options, but diversifying expiration months or staggering options. If you are selling options on your own, you can use this strategy in your own portfolio to increase your consistency.
Staggering short options is a popular strategy with both income and total return investors. You may hear some comparing this strategy to building a bond or CD “ladder,” in which you have paper maturing in every month of the year. The strategies are similar, though your option premium ladder will carry more risk with the potential for higher returns. It can play a big role in the consistent performance of your portfolio.
Staggering, or “layering,” your options involves selling groups of options with different expiration months, with the end objective of being a certain amount of options expiring every month.
For instance, an investor wanting to stagger his portfolio may take the following approach:
The objective is to set the portfolio up so that you have options scheduled to expire in every month, thereby providing a steady stream of income or rate of return. By the end of the first 90 days, your first set of options will be expiring. As these expire, you continue to roll them into another set of options 90 days out and continue this cycle throughout the year. Of course, you could do this at 120-day or 150-day intervals as well. However, by incorporating this ladder-building approach, you should have at least some options expiring nearly every month.
You can employ this strategy using options in the same market along with options in different markets. As most commodities options do not have options available in every month, a mix- and-match approach often works best. For instance, one could sell crude oil options the first month, coffee options the second month, soybean options the third month. If the same supply/demand fundamentals continue, you could repeat the cycle at the beginning of the fourth month or mix in some financial options.
Advantages of building your premium ladder
Positioning in this way offers you two major advantages: It can provide a more consistent stream of income, and it can be an effective tool in helping to manage your risk. As options approach expiration, their ability to cause one losses diminishes. By staggering your options, the risk is effectively spread around between low risk and higher risk options. The highest risk options tend to be the newest options that you’ve just sold--the ones with the most time. As time goes on, the risk diminishes--especially if they remain deep out-of-the-money.
If you plan to use option selling as a core portfolio strategy and not just an occasional way to generate excess income, using a premium ladder is a key method of building smoothness and consistency into your overall approach.