TSLA - Income Investing On Steroids: 39 Trades To Potentially Generate A Big Fat Yield

2023-06-27 07:00:00 ET

Summary

• With the cost of living has increased dramatically, we're all seeking ways to increase our income.
• Getting double-digit yields with high-yield stocks is a risky proposition.
• However, exploiting human nature, we can safely generate higher yields with cash-secured put options.

Written by Sam Kovacs

Introduction

There's a certain appeal to income investing, especially in retirement.

Instead of having to sell a portion of your capital every month to cover expenses, and see the balance of your net worth slowly decay, what if you could leave your principal untouched, and rely on the income derived from your positions to cover expenses?

Market goes up? Get paid. Market goes down? Get paid.

It is an approach to investing which just makes sense as it matches cashflows from your assets to your monthly expenses.

Now income investing takes many forms. You can invest in equities, bonds, BDCs, preferred shares, or as I'll suggest in this article, a portfolio of short puts options.

Last week we presented the strategy highlighting that it offered better downside protection than investing in high yield stocks, while offering superior returns.

The only real negative, which for some investors is a deal breaker, is that it takes a bit of time. Maybe 20 minutes a day to execute the trades.

But let's think about it this way.

If you have $500,000 to live off in retirement, and you can get an 8-10% yield by investing in high yield stocks (while having to deal with risks of dividend cuts, the volatility of your capital and so on), then that would give you $40K to $50K per year.

Now if you can get a 16% yield on your portfolio, then that's $80K per year. That's another $30,000.

I'm sure you can think of a few things you can do with an extra $30,000. The hourly rate of spending that 20 minutes per day 5 days a week is $346, and that's assuming equity investing takes no time (obviously not true).

I feel like that's a pretty good deal, and I'm sure a lot of you will agree.

In this article I will briefly summarize the strategy, and explain the psychology of why it works and persists through time, and how you can exploit it today.

The strategy overview

The strategy involves selling out of the money cash secured puts in an intelligent way.

We screen over 100,000 options every day, to find those which offer an attractive annualized yield (we focus on the 10% to 20% yielding options). In this way we are getting tech to discard options which won't pay us a large amount to underwrite their risk. Then we apply a large number of risk controls to minimize the chance of assignment. The vast majority of our options will expire worthless. We then sell another option.

In a small amount of cases (empirically less than 2% of time year to date, although we have a provision for up to 5% of the time), the stock will dip below the strike price, meaning the option risks being exercised. We do not want to be assigned, so we decide to buy back the option, at a loss, rather than risk holding a bag. This reduces our market exposure significantly, and cuts the long tail losses which can exist within a short put strategy.

For a more detailed overview, please read the article I linked in the introduction.

Why the strategy works

To get different returns than most investors, you need to be doing something different.

This is why The Dividend Freedom Tribe's portfolios have all done better than the index since inception: We were different and we were right.

To have a durable investing strategy which you can replicate at scale, there needs to be a long lasting structural bias which makes the strategy exploitable.

In our case, we are selling puts, which means that there is someone who is buying the put.

If we're going to derive durable superior returns, our counterparty needs to have certain biases which favor us, and make him the loser.

My grandfather used to say "a mug is born every minute, the trick is to know where to find them".

There are two groups of people we are looking to sell options to:

• Insurance buyers
• Gamblers

Both of these groups of people have biases that put them on the losing side of the trade way too often.

Gamblers are found especially with the shorter term options (less than 10 days to expiration). These gamblers are willing to pay a small premium on the off chance that the stock will fall through the roof and they make a profit. Human psychology is such that gamblers lose money on average. An old WSJ study suggested that 89-95% of gamblers lose money.

When we can compute that you'll be paying us an annualized 16% yield for a 2% chance that you're right and we're wrong, we're willing to take that deal again and again.

What's more is that we can often buy back the option when we do lose, minimizing our losses. (We estimate that you'll give back about 2% of that yield to cut losses long term).

Gamblers are great trading partners, because they are acting irrationally.

Insurance buyers are also irrational, by no fault of their own.

At its core, a put option is an insurance contract. The buyer insures himself against the risk that a stock might drop below a certain price. They usually believe this is a sound hedge for them to potentially minimize their losses.

But the problem with insurance, is that whether we're paying for health insurance, or stock insurance (by buying a put), we overpay. Humans are naturally risk averse. Countless scientific studies point to this.

Here is a snippet from a 2014 paper which summarizes some of the research proving this:

Risk aversion is one of the most fundamental properties of human behavior. Ever since pioneering work by Bernoulli (1) on gambling and the St. Petersburg Paradox in the 17th century, considerable research has been devoted to understanding human decision-making under uncertainty. Two of the most well-known theories are expected utility theory (2) (an axiomatic formulation of rational behavior under uncertainty) and prospect theory (3) (a behavioral theory of decision-making under uncertainty). Several measures of risk aversion have been developed, including curvature measures of utility functions (4, 5), human subject experiments and surveys (6, 7), portfolio choice for financial investors (8), labor-supply behavior (9), deductible choices in insurance contracts (10, 11), contestant behavior on game shows (12), option prices (13), and auction behavior (14).

It is likely that risk aversion is hard wired into humans, and also non-human animals, because it gives us certain evolutionary advantages. It has some interesting ramifications when it comes to economic behavior. It is the reason we buy health insurance, car insurance, home insurance, and life insurance.

We are not rational beings, and we value protecting our downside. That means that we are willing to overpay to protect downside risk. This is why insurance companies make a profit: They collect more premiums than they pay out.

If humans weren't risk averse, insurance companies wouldn't exist. I therefore posit that option sellers can exploit our tendency for risk aversion.

How much time does it require to implement this strategy?

Of course, everything comes at a cost.

Generating 14%-18% yields in a safe controlled manner with option trading, comes at the cost of time. If you have $1,000,000 to deploy with our strategy, you could confidently do that in 5 trading days.

With our current tech, It would take about 30 minutes a day to deploy all the trades manually. With an average DTE of 30, you'd have to do that once a month. That means that you're spending 3 hours (rounding up) per month.

If you were previously getting 7%, then it means that your 36 hours per year would generate an extra $70K-$110K per year.

Now my elementary math skills tell me that's a fair hourly rate. Even if you add in another hour per month to put in orders to repurchase the bad trades, it isn't overly intrusive.

The risks of the strategy

The risks of the strategy come from the downside exposure you have from being short puts. While we secure all our trades with cash as a way to be conservative and not take leverage, it is never our intention to take assignment of any stock.

Because of the reasons I explained above, the yields you can get on puts far outweigh those you can get on calls, so it is a losing proposition to take assignment.

Rather, in the instances when stocks dip just below the strike price, we prefer to buy back the option, take our loss, and move on.

Consider this mathematically.

With the Upstart ( UPST ) put option which expires on July 14th at a strike of $23.5, which you'll find in the table below, you can get a $0.32 premium to sell it at the bid. If you place a limit order above the bid, you can potentially get more if someone hits your ask.

But if UPST were to tank 22% over the next 2 weeks, and the stock price dipped below $23.5, then we would be inclined to repurchase the option.

Let's assume this happens faster rather than later on our timeline of between now and expiration. There would still be quite a bit of time value, and now we would be looking at some intrinsic value in the option as well. We might have to pay as much as 7x the price we sold the option for.

Let's assume this would be the case, you'd have to pay $2.24 to repurchase the option. This is an 8% net loss on the capital you secured for this put. This is a big loss compared to the 1.32% you stood to make in just over two weeks.

But the question you need to ask, is how often would this loss happen in the long run? We perform our arithmetic assuming that 5% of the options you trade would be assigned.

In reality so far the numbers have been closer to 2%. But better safe than sorry.

In this case, if you could sell this exact UPST option 20x, and lost 1, then at the end of it, you'd still be generating a net yield of 18%. That is net of losses.

The long tail risk is that a black swan event causes a stock to gap open much lower than strike at market open, in which case we have to take a bigger loss.

In any case, by diversifying your options portfolio across stocks, sectors, expiration dates and strike prices, you significantly dilute the impact of any event. By avoiding earnings dates, you remove a large part of the day to day market volatility.

Proper risk management means that you can generate very generous yields even while taking a certain amount of losing trades.

It is after all, a number's game.

Option Trade Ideas at market open

Here is a list of option trades which I will be looking to trade at market open.

Remember that the yield you get is highly dependent on the price you can get for each option, and that these prices might move at market open, in or out of your favor.

There is extra sensitivity for those with lower time to expiration.

I have provided two columns for yield: one gross, and one net of commissions, assuming a $1.4 commission per contract which is the highest I seem to pay when trading a single contract with Interactive brokers.

It is important to look at the yields net of commissions, especially when it comes to options with low premiums and low days to expiration, as the yields can be seriously impaired.

If you were to just sell one option of each of these contracts at the bid, then you'd generate an overall yield of 16% net of commissions and need $233,000 to secure all the puts. You'd have a weighted DTE of 22, and a weighted 5.6x standard deviations of safety before being assigned (meaning you expect very few assignments).

Conclusion

Selling put options in this way is a novel approach which offers a durable, long lasting opportunity to generate superior income in all market conditions.

To do so successfully, the right risk measures need to be incorporated.

Over the next months, the Options By Kovacs account will be sharing more on our options strategy before we open it up fully to the Seeking Alpha community.

We will be providing followers with blog posts analyzing the performance of all the options on the trade lists as they approach expiration and expire.

For further details see: