The market had a pretty bad day today, especially in the vogue stocks like Bitcoin, Tesla, EVs, and other "cool" sectors. One of the stocks we sold puts on, RIOT, tanked 24% today.
We didn't care.
See that fellow in the hammock? This guy --->>>.
Since we started selling options, we tend to be like this guy. We might get a text from our friends during the day with something like "Holy cow did you see the market this morning?" and we see it's all red. We used to care about that but now we don't.
Neither should you.
Let us explain why. There are two main reasons: the cushion and trade management.
FIRST: The Cushion.
If you've read our Seeking Alpha article about busting options myths, we talk about using a big "cushion" with our trades. What that means is we keep far away from the price.
<-- Kinda like that car.
Keep a good distance from trouble, and trouble is less likely to find you.
We sell options way, way below the price. When we sold our RIOT $32s, RIOT was in the 60s. Now it's in the 40s. Maybe it goes down into the 30s and then we start to plan an exit (see #2 below). But right now, our RIOT $32s are still 37% from the price.
Why worry now? Will it help? It won't. And 37% is still a long way to go.
You must remember that when we sell puts way out of the money, we win the exact same amount (the premium) regardless of whether the stock ends up $0.20 above the strike or $20 above the strike at expiration. That $19.80 swing doesn't affect our lives one whit.
Below is a table of all the cushions currently on our open trades as of EOD today. They are all above 20%. Since we don't start to plan exits until we see single-digit cushions, we consider today's negative price action to be a big nothingburger.
So, literally, we scan this table, shrug and then go about our lives. We don't check stock trades wondering what to do every time they move downward. The options selling mindset is liberating.
SECOND: Trade Management.
Selling puts gives so much more flexibility than buying stocks (or buying options for that matter; buying anything is for the birds). What happens if a stock or option that you bought long is now below your cost basis? You can't do much about it except wait for it to go back up. Sure, maybe you can start writing covered calls, but now you're selling options. What can you do to manage a losing long trade without selling options? You have to pray for a turnaround, even double down maybe, or else get out and take a loss. You have very few options and none of them is appealing.
But when you sell options, trades that go against you are much easier to manage. Let's take that RIOT $32 and assume it drops down to $28 by March 5 and is worth $6. Ho boy, what then? We sold those for $1.85 and now we're down $4.15?! Ouch.
Don't worry: it's not as bad as it seems. While we plan to write a more sophisticated article later on trade management, below is a summary of some of our management options:
(i) We can wait. Those RIOT $32s don't expire until March 19. That's a long way off and there's a lot of time premium on those puts ($2), especially since it tanked and volatility is up. We don't want to worsen our losses by paying for that to cover our trade now. Waiting until it's closer to expiration earns us another $2, even if the stock stays at $28. Our paper loss is already not as big as it might seem.
(ii) We can double down. Sell more $32 puts? Sure! They are worth $6 whole dollars. Say we sell some more, and now we own 2 puts with a cost basis of ($1.85 + $6) / 2 = $3.925. We have now moved our breakeven point from $30.15 down to $28.075. Hmm. Now we're basically at breakeven! Sounds good but watch out: if RIOT keeps falling, then we lose twice as fast. Thus, we save the double down for when we are confident the stock will rise. And since we hate to guess, this means we generally avoid double-downs. But, you can see it's an option.
(iii) We can roll out. We love the roll out. This simply means that we buy back our puts and sell the same puts at a later expiration. Sometimes this can magically turn a loss into a win. As you all know by now, the key to options selling is the time premium. If we rolled out our RIOT $32s from March 19 to a later expiration, we get more time premium. We can always roll for a credit if we keep the same strike price, which reduces our breakeven point. Eventually, with enough roll outs, we can try to get that breakeven point back below the stock price. Often, we can roll out and also lower the strike price (a "roll out and down") for a credit, which is even better than a plain roll out, because we get a lower strike price and more premium in the deal. Again, when rolling, because we are buying back our option in order to sell another one, we want to wait until all the premium is used up before rolling. Thus, we would likely wait until just before expiration and then roll (but only if we have to).
(iv) We can take the loss. Dang, that sucks. But remember that we like to sell options with delta less than 10%, which means we typically don't see losses more often than about 1 in 10 times. So yes we might lose $4.15 on this trade, which is $4.15/$30.15 = 13.76% loss. But it's only one trade. If you follow our 10% allocation rule, that means only 1.376% for your overall portfolio. Not a disaster at all. Also, the size and frequency of winning trades in our system has more than made up for the losses. That's the power of the "Expected Value" that we described in our blog on Calculus As Our Co-Pilot. As we explained there, losses can and do happen, but as long as your wins make up for your losses, you're going to profit in the long run.
None of this is to say we are immune to loss. But we are poised to manage loss better than long stock or option systems, give the ability to sell more premium in the face of a downturn.
Never fear... We got this. You don't have to know anything about what we've just been saying. If our trades ever need to be managed, we will send you trade management signals telling you exactly what we would do. These will be in the "follow ups" section of the daily email or else we will send you a separate email. Like what we did for GNUS recently! We adjusted the profit-taking exit order down because the price had fallen and we wanted to reduce the time we were in the trade. And then boom, the trade closed out a winner. We hope you had the same experience with GNUS.
Today we had another winner: our LODE puts closed for a 7.55% gain.
Our year-to-date stats are great:
85-0, +31%, which is 213% annualized.
Average trade is 4.79%, average duration 8.2 days
Please feel free to ask us any questions!
Marc and Laura