According to this article (which I found via googling, “picking up pennies in front of a steamroller”, so take it with a grain of asphalt…), “The term `picking up pennies in front of a steamroller’ is linked to Nassim Taleb, an acclaimed author on randomness and risk, whose books describe an investment strategy that has a high probability to yield a small return (pennies), and a small probability of a very large loss (steamroller).”
I didn’t look further into what specific types of investments Taleb wrote about, but one clear example, at least through the lens of this blog, is writing puts and calls in options trading. We are collecting “pennies” at high probabilities, but once in a blue moon the “steamroller” is going to sneak up on us. Will all the pennies be worth it? Well, that of course depends on how shiny those pennies are and how many you pick up.
Let me tell you about how I just got steamrolled by over $1,100 while picking up $55 worth of pennies. The steamroller was $FCEL. I opened a position on FuelCell Energy on October 8 by purchasing 100 shares at $2.34. I then went on to sell multiple covered calls over the next couple of months at the $2 and $2.50 strikes, proudly picking up $10 to $15 at a time. With a $234 initial investment, each of those premiums represented a 4-7% return!
Things were looking just fine until mid November when the stock price shot up, way past my strike price. The price eventually reached over $10 (and over $13 today)! Had I not had that covered call position at $2.50 strike expiring December 18, I would have been up almost $800. A 336% return! Instead, I got my $55 worth of premiums and $16 in capital gains… a ~30% return.
Well, the short answer is no, I didn’t learn a lesson here. I am still selling covered calls on positions. There is one thing I might do differently with these types of positions in the future.
$FCEL was a pretty speculative play. In fact, my original covered call was an in the money call at the $2 strike. I expected to make about a 6% return after selling for a capital loss and be done with it. I didn’t know if it was going to go up, down or sideways.
In the future, if I’m in a similar speculative play, I could potentially participate in the upside by buying “protection”: buying a cheap, long call at a strike price way out of the money. This would make my covered call a call credit spread. For example, if I had bought a call at the $4 strike, it probably would have only cost me a couple bucks. Sure, my return if the contract expires out of the money would have been those couple dollars less, but I could then have participated in the upside a bit. In this case, if I had a long $4 Call position, that would have been worth over $600 when the stock rocketed up past $10!
A couple days later, the book arrived and I literally read it in one afternoon. It’s short at just 98 pages. Chris gets straight to the point and clearly lays out the reasons why his “Ultimate Liquidity Portfolio” is better than stashing emergency (or opportunity) funds into “high-yield” savings accounts as I had been doing. Currently, I’m earning 0.4% APY on my high yield account. When you account for the Fed’s current target inflation rate at 2%, it is obvious that you are losing money everyday it sits in your account. The book has several charts and graphs showing just how much buying power cash has lost in the past. But there is obviously some value to knowing that the money is safely set aside and liquid for whenever it is needed.
Other Assets & Volatility
So how do you keep up with inflation? The typical answer is to buy assets. Gold, stocks, real estate… most assets will rise in value with inflation, though generally with volatility as well. The downsides to putting all of your emergency funds into any one of those assets are obvious. When you need to pull $1,000 out, for example, you want to know your asset is still worth $1,000 (not less) and it can be easily liquidated. It’s clear you aren’t going to be able to sell off a little bit of real estate every time you are in a crunch.
Also consider the reason you need access to these funds. Perhaps we are in a bear market (e.g. because of a pandemic!) and you just lost your job. If you had your “emergency” funds in the stock market, you’d be forced to sell at the same time as everyone else, losing a good chunk of your value just when you need it. This is why FDIC insured accounts like high yield savings accounts are so popular despite such low rates of return.
Diversification: The Perfect Mix
Chris has a great metaphor in his book for a perfectly diversified portfolio. Imagine you are a farmer with hens. There are two types of hens: ones that lay eggs on sunny days and those that lay eggs when it’s not sunny. If you have both types of hens, you know that you will get eggs whether it is sunny or not. This is what you want in an emergency fund, one that continues to grow in both booms and busts.
So how is this achieved in practice? With a mixture of bonds and stocks. But this isn’t your typical 60-40 stock to bond ratio. Such a portfolio is likely to grow over the longterm, but will still have more volatility than you want. Remember, you want eggs on cloudy days, too.
Chris’s solution is a mix of 88% intermediate term US Treasures and 12% US total stock market. Intermediate term treasuries mature in approximately 5-10 years. The two generally move in opposite directions, especially when there are big moves in the market. For example, see the chart below showing $VGIT vs. the S&P 500 this year. Just when the market was crashing in March, $VGIT started laying eggs!
Since 2009 when $VGIT was formed, it has had a -0.43 correlation to the US stock market. The 88/12% combo of $VGIT and $VTI have a combined correlation to the US stock market of just 0.11. When the stock market is zigging and zagging, the ULP is just steady.
If you put $10,000 into $VTI in that time, you’d have $41,923 (13.9% CAGR), but with a max drawdown of over -20% and worst year of -5%. $10,000 in $VGIT gives you $14,381 (3.36% CAGR) with a max drawdown of -4.3% and worst year of -2.8%. The ULP slightly increases the return of the 100% bond portfolio and actually reduces drawdowns. $10,000 in the 88/12 ULP gives you $16,568 (4.7% CAGR) with a max drawdown of just -3% and worst year -2.2%. This is with an annual rebalancing. Remember that this is only looking at a short time frame in which there was a historic bull market — in other time periods, as the book shows, the ULP returns compare even more favorably with the stock market returns.
One final benefit of the ULP over savings accounts is the tax advantages. Tax implications should never be the primary driver for an investment choice, but a secondary benefit is always welcome. Interest income from the savings account will be taxed as ordinary income. Dividends from the $VTI portion are qualified, so therefore will be taxed as more favorable longterm capital gains, which is 15% for most (including myself) at the federal level. In addition, for those of us in higher taxed states, the dividends from US Treasuries aren’t taxed at all at the state and local level.
Implementing the ULP
Interested in implementing the ULP for yourself? First, I suggest you get a copy of the book first before throwing your life’s savings in it. Chris is much more qualified to give financial advice than I ever will be.
With that said, the easiest way to achieve this is with M1 Finance. M1 Finance allows you to create your portfolio with multiple “pies” where you split your portfolio among different slices. Each slice is a unique ETF or stock. In this case, the ULP pie is 88% $VGIT and 12% VTI. You can view this pie on M1 Finance here.
One question I’ve been wrestling with is how much to put in the ULP vs our savings accounts. Chris’s book devotes a chapter to determine how much should be in an emergency fund. He discusses unexpected costs (home repairs, healthcare expenses, auto repairs, etc.) as well as loss of income. You often hear of 6-12 months of expenses should be saved in the emergency funds. Because my wife and I both work, I actually did a calculation of how much we need to cover 6 months of our expenses living on only one of our incomes (the smaller of the two incomes). That is the goal to reach in my ULP account.
Our unexpected costs — which includes $3,000 for an expensive car repair (e.g. transmission) + 1% home value + $3,000 for a home repair (e.g. A/C repair) and the difference between our maximum out of pocket healthcare expenses and our HSA balance — are what we plan to keep in our savings account going forward. I’m not going to go over the exact numbers here (I’m realizing this is getting quite complicated and might deserve its own future post), but will say that the target values for the ULP and savings account come out to be fairly similar amounts.
After reading Chris’s book, I am convinced that investing some of my emergency fund into the ULP will better preserve, and potentially grow, the value of those funds compared to a high-yield savings account. I have started to implement the ULP at M1 Finance, which makes it easy to achieve the desired allocation between $VTI and $VGIT.
Chris has a blog with some interesting personal finance posts as well as some health related posts (that I haven’t really read) at upwarding.com. I commented on one of his posts and he replied via email. I was very impressed with the time and thoughtfulness he put in his correspondences with just some random reader.
Disclaimer: I am long $VTI and $VGIT. I am not a financial advisor. This is not investment advice. Please do your own research before investing in anything discussed herein. This post contains affiliate links.
Since writing that post, $F price went from $8.80s to almost $9.50 and now has pulled back down to nearly $9 again. We all know volatility is great for options sellers!
Here are the trades I’ve made and the current positions I have open:
Prior to writing that post, I actually had two open covered call positions on $F, one that was right at the money at $9 due to expire on November 20. Rather than risking the shares being called away, I closed that position and sold the December 24 $9.50 Call for a net credit of $.11. $.11 may not sound like a lot, but if that was a dividend payment, it would be the equivalent of an 11.5% yield! I used that credit to buy 1 share of $F for $9.00.
I had another $9 Covered Call position for December 18. I rolled that one out to January 15, this time keeping the $9 strike price. I took in a net credit of $.16 that time (11.9% annualized yield). Again, I reinvested that net credit by purchasing one share of $F at $9.10.
On December 3, I rolled the December 24 $9.50 out again to January 8 for a net credit of $.11 (10.7% annualized yield). I purchased one more $F at $9.26 with the credit.
On December 9, I rolled the January 15 $9 Covered Call (which is now pretty well in the money at this point), out to February 19 for a net credit of $.21 (11.3% annualized yield). I then purchased two $F at $9.43 with the credit. It’s unlikely $F will come down below $9 by February, but I will continue to roll this one out for as long as possible.
As the price of $F continued to tick up, I decided I wanted to try to roll out and up this time. I took that $9.50 January 15 covered call and rolled it out to February 19 for a net credit of $.08 (7.9% annualized yield). Since I didn’t get enough in credit for this one to buy another share of $F, I just pocketed the cash. However, it puts me in a great position to start selling covered calls at the $10 or higher strike price in the future.
Overall, I have taken in $67 of credits, less commissions, by doing this strategy over a fairly short time period. Let’s say that $67 was the quarterly yield amount for holding 200 shares of $F at the current trading price of $9.03, that would be equivalent to a dividend rate of 14.8% ($67 * 4 / (200 * $9.03) = 14.8%)!
I always want to be mindful of what risks I am taking. 14.8% yield sounds pretty good for a savings account, but of course, this isn’t in an FDIC account. This is real money that could be lost. With that said, before beginning options trading, I was OK with the risk of holding $F, at that point, because I thought the reward of the dividend payments and maybe some modest growth was worth it. In that case, I have no more risk than I had prior to selling these covered calls.
On the other hand, I have limited my upside potential. This isn’t a risk per se, but may make the risk I am taking less worth it. Some argue that option selling is the wrong kind of asymmetric risk… limited upside and unlimited downside (although in this case, the downside actually is limited because the stock can’t go below $0, but you get the point). To that, I would ask them would you rather be casino or the gambler? I’ll pick playing the casino every time. In addition, I’ve demonstrated that sometimes you are able to roll positions up to allow for even more upside from the stock. This is often an option so long as the stock hasn’t had an incredible run up in a short amount of time. And if it has, since I have been reinvesting my credits back into the stock, I still get to participate somewhat in that upside.
I do hope that Ford chooses to reinstate its dividend in 2021. There is still lots of chatter over at SeekingAlpha on when that might occur. However, as long as I am able to continue to roll out and, hopefully, up, I won’t be missing it much!
November was an incredible month for the markets. The S&P 500 rose 10.8% for the month and hit an all-time high. The Dow Jones’s 11.8% return for the month is the best single month since January 1987!
Because of my option writing (aka selling) strategy, my option trading returns weren’t able to beat the market. However, a large portion of some of my portfolios remain heavily invested in the markets, which keeps me from feeling too much FOMO and giving me the confidence to continue on with this strategy. I’m looking for lots of base hits here, from month to month. Over a long period, I think I can outperform the market, but only time will tell.
For the month of November, my profits from option trading were $2,114. That’s a total portfolio return of 2.3%, which is well below the S&P 500’s 10.8%. My total portfolio value across all accounts – which includes options trading profits, current stock & options positions, contributions & withdrawals for extra mortgage principal payments – was up 10.7%, inline with the markets. Contributions to these accounts were small this month, and $114 was withdrawn, so actual return is probably right around 10%. Remember that the markets were down 2.5% last month, and I generated options trading profits then, too. I closed 71 trades with a win percentage of 91%.
I continue to split my accounts between two strategies. One is to trade mostly credit spreads in margin accounts and the other is to sell cash-secured puts & covered calls (i.e. “the wheel” strategy) in non-margin and IRA accounts. The goal for the margin accounts continues to be to 1) raise cash to increase trading capital and 2) run through my mortgage pay off strategy. The other accounts are reinvesting the profits into stock positions for future growth or passive income via dividend stocks.
Last month almost half of my profits came from my margin accounts despite being just 11% of the total portfolio size. Many of my non-margin accounts had longer holding periods with expiration dates further out, so I realized a lot more profits in those accounts in November than I did in October. As a result, 84% of the profits came from the non-margin accounts this time. The margin account profits were a 3.7% return on total capital (43.1% annualized) and the non-margin profits were a 2.1% return (24.7% annualized).
10% is often cited as the historical annual performance of the S&P 500 since the 1920’s. Every month that I am beating that annualized return with options trading profits (and I crushed it this month with a combined 27.4% annualized return) and my total portfolio value is roughly inline with the overall market when it’s up (which I was within by about 1%), that’s a huge win. Just a couple years of this type of performance will have huge effects in my family’s longterm wealth creation. Let’s see if we can continue!
My best trade for the month in terms of profit was a wide Put credit spread on $FSLR. First Solar has been moving a lot over the last few months so the option premiums are really good. My original intent was to sell a cash-secured put (“naked put”), but decided I wanted to take some of the risk off the table so went with the spread instead. On November 13 I sold the $76 strike December 4 Put for a $2.04 credit and bought the $65 strike December 4 Put for $.35, giving me a net credit of $1.69 before commissions. When the stock moved up shortly after, I decided to close the position to lock in most of the profits on November 20. After commissions, I ended up with a profit of $130.36 on a 7-day trade which is an 11.9% return (541% annualized).
With the initial credits I actually purchased 1 share of $FSLR for $80.30, which is now up 11.9% to $89.26.
My biggest realized loss was $52 on a Call credit spread on $SPY. On November 2 I sold the $348 strike December 2 Call for a $3.57 credit and bought the $349 strike Call for $3.26, for a net credit of $31 (commission free trades with Robinhood). This trade had a 74% chance of profit when I placed it, making the $31 possible gain with a $100 risk worthwhile. However, the market went way against me and I decided to cut my losses early on November 9 for a $52 loss. In hindsight it was the right move because the market just kept going and going, so I saved myself another $17 in potential losses ($100 risk – $31 credit – $52 loss = $17).
This trade was part of a strategy I coined “ETF Challenger” that I mentioned in previous posts. Essentially I am challenging the ETF to continue moving in the same direction when it made a greater than 1% move. So when $SPY is up more than 1% on the day, I sell a Call credit spread above it near the .30 delta (Investopedia: Understanding Position Delta). If it’s down more than 1%, a Put credit spread. I’m seeing just as many losers as winners on this, so I’m probably going to be ditching it going forward.
My biggest paper loss is actually much worse than $52. I sold the November 20 cash-secured Put on $GOLD at $27.50 for a credit of $.30. At expiration, the stock was trading down at $24.28, so I was assigned the 100 shares at $27.50 and immediately had a paper loss of $292 (+$30 – $2,750 + $2,428 = -$292). Unfortunately $GOLD has continued to pullback to $23.50 currently. I took in a small credit $7 credit for selling a December 18 $28 covered Call, which makes my current paper loss at $363 (+30 +7 – $2,750 – $2,350). I’m going to be patient with this one and continue to sell covered calls above my originally assigned price of $27.50. This position is in an IRA, so when I look at a horizon over many years I expect there to be an instance where I will want the hedge against the market in gold (while $GOLD is actually a mining stock, it generally moves in the same direction as the price of gold).
Funding ROTH IRA
My last update for the month of November is that I finally funded a ROTH IRA! My wife and I are still under the household income limits for funding a ROTH, but I hope and expect that to no longer be true at some point in the future. I’m hoping to be able to fund that account with the maximum limit of $6,000 until we no longer qualify.
The obvious benefit of a ROTH over a traditional IRA is that future withdrawals are tax-free. Because of this, I’m hoping to create a stream of dividend income that can grow to a sizable amount at age 59.5. At that point, we will be able to take those dividend payments out each month/quarter and pay no taxes on them! For now, I’m planning to build the portfolio with REITs. My first trade: a cash-secured put on Realty Income $O, of course!
The second benefit I like about funding a ROTH is that, since contributions have already been taxed, they can be withdrawn at any age without penalty. It can essentially be used as a savings account where the principal is always available but the interest can’t be touched until age 59.5. My wife and I are keen on getting more involved in real estate, which means we will have a need for capital at some point in the future. By funding the ROTH rather than putting more money into a traditional IRA or regular 401k, we aren’t giving up control of that money for the next 30+ years.
I am very happy to report that my second month was even better than my first: $167 in profit! This is a 6.2% return on capital for the month of November (75% annualized).
Thanks to the overall market’s strong month, my long positions went up and I was able to completely reverse the 16% my principal was down. It is now at $3,240.86, which is 1.3% higher than the $3,200 I have added to the account thus far.
My positions & trades
$AAL, 109 shares at $13.98 ($1,523.73 total principal). Principal is currently up 2.3% ($34.97). I closed a total of four positions for a profit of $34. I currently have a $15 covered call position that I expect to collect another $34 from on New Year’s Eve.
$34 is a 2.4% return on my initial principal on American Airlines, well above my 1% goal each month, but much lower than the total portfolio’s returns of 6.2% for the month. The higher returns came from the other positions this month, but I’m happy to hold onto American Airlines for now. I think it will continue to move up and down with the COVID vaccine news, and I plan to ride that wave.
$FCEL, 100 shares at $2.34 ($233.78 total principal). At the close of November, Fuel Cell was trading at $10.18. That’s a 335% return! However, I sold a call option at $2.50, meaning my upside is limited to just $16, or less than 7%. Picking up pennies in front of a steam roller is a common metaphor used for selling options, and I think this is a perfect example of that. I plan to have a future post on this after it all shakes out. It will have a catchy title like, “How I missed out on $784.”
As for the trades, I had a $2.50 call option that I collected $15 on due to expire on November 20. Rather than letting the shares be called away, I decided to roll the $2.50 to the next month for a net credit of $10 (the November contract was bought for $1.55 and the December contract was sold for $1.65). This is basically a guaranteed $10, or 4% return on the $250 principal I would collect if/when the shares are assigned. For me to lose money on this, the stock would have to retreat all the way back below my purchase price of $2.34. I am now so far in the money that I’m not sure I will be able to continue to roll the position for a profit. However, I will still try as long as I can get 2% or so.
$M, no open position. Macy’s is another stock that I missed some big upside gains on. However, I was able to milk it a little more than the $FCEL trade. I closed two trades for the month, netting me $54 on a position size of $617, which is an 8.8% return. When I finally had the shares called away at $6.50 on November 20, I profited $33 on the sale, but missed out on an additional ~$250 since the stock was then trading near $9. The stock is now above $10. I most likely won’t enter $M again unless there is a pullback.
$GPRO, no open stock position. Go Pro was my third position that was called away this month. I had 100 shares at $6.46, and the shares were called at $7 on November 6. You can see in the chart below that there was a big spike that I got caught in.
In total I closed three trades for a net profit of $52. I currently have a $6.50 put due to expire this Friday, December 4. It is only an $8 credit, but that exceeds my 1% goal and was only a one-week contract. I expect to trade more cash-secured puts around the $6-$7 level going forward.
$APHA, no open stock position. Marijuana stocks are going nuts right now and option premiums are juicy. Aphria has been especially volatile due to a recently announced acquisition of Sweetwater Brewing Company. I currently have a $6.00 cash-secured put contract for December 11 that I collected a $17 credit on (2.8%). If I get assigned, I will sell a covered call in the $6.50-$7 range most likely.
Extra Mortgage Principal Paid
With $167 in net credits earned for the month, I am setting $53 aside for tax purposes. Last week I said I would be using $GNMA for my “tax escrow.” I have since been enlightened with the “The Ultimate Liquidity Portfolio” (ULP). I will have a forthcoming post on the idea as well as the book How to Stash that Cash by Chris Kawaja. In practice, the ULP can be implemented by putting 88% into intermediate term treasuries (e.g. $VGIT) and 12% in the US total stock market (e.g. $VTI). This puts my tax escrow account value at $99.82 as of this post.
So after taxes, I’m left with $114 that I decided to put directly towards my mortgage principal. With a combined $187 put towards my mortgage principal after two months, I will save $288 over the life of the loan.
In my introduction post I identified three different benchmarks I will be comparing my performance to. Benchmark #1 is putting all of my savings from my refinance, plus a 1 month skipped mortgage payment, into a savings account. When I wrote that post I was actually getting 0.6% APY, but it has reduced to 0.4%. Benchmark #2 is putting all of those savings straight into extra monthly payments to the mortgage principal. Finally, Benchmark #3 is simply buying $SPY.
After losing to all three Benchmarks in my first month, I am now well ahead in all three. When considering the value of my principal in my trading account + the monthly contribution of $64.21 and interest into my savings + the difference between the original loan and what is actually remaining this month, my total value is at $3,356 after the month of November a 27.8% improvement over October. That beats Benchmark #1 (all savings) of $3167 by 6.0%, Benchmark #2 (extra mortgage payments) of $3,172 by 5.8% and Benchmark #3 ($SPY) of 2.2%. I’m pretty impressed that I managed to beat $SPY since November was the best month in the market in over 30 years.
I plan to put all these details onto my Using Options to Payoff My Mortgage Early page, including some tables and charts to show my progress from month to month. I’m still trying to format that so it’s easy to read, but hopefully I get that done before the end of the year!
Thanks for following along. I’m very happy with my progress, but it is just early days. Please don’t follow what I’m doing without doing your own research. Trading stocks and options can be risky. I hope you are inspired by these series of posts and my website to learn more about the strategies I am using to trade options and build wealth rather than attempting to follow blindly.