It's designed to sell option premium on major indices (like the S&P500 or NASDAQ-100) to generate mostly passive income, with a fairly reasonable risk-adjusted return. It uses a combination of strategies that involve selling naked puts and covered calls, which both have the same risk profile, but naked puts tend to have higher premiums.
I doubt there is much left after commissions. See [0] for a backtest including commissions and [1] for a blog post from ORATS on how to backtest the strategy using the ORATS backtester.
[0] https://www.reddit.com/r/options/comments/j3ofna/the_wheel_b...
[1] https://blog.orats.com/backtest-basics-how-to-set-up-the-whe...
The financial industry would not just leave that much risk-adjusted return on the table, after all. Just because a strategy is complex does not mean it is lucrative.
The Wheel as a strategy doesn't scale well, though. A good stock for the wheel has relatively low volatility, but with high volume of option interest. These two things are kind of opposed to each other, though. If a stock isn't very volatile, then there isn't much need for large option interest.
Of course there is a lot of overlap where things get interesting.
I think the reason why there aren't a lot of institutions running the wheel et. large. is because it just can't work at the scale they want to operate on. You can probably run the wheel pretty successfully at a million in capital (much larger than I'm used to), but at 10, 100, or 1 billion, it just doesn't work.
And what are they going to do? Pay some guy 200K to generate maybe 200K on a million in capital?
Of course, you might have better luck wheeling on something with much more implied risk than SPY or cycling through some of the most risky stocks. But depending on where you are in the wheel, you are still yourself assuming risk that can make you lose money (e.g. a collapse in implied risk while you hold the stock).
When you say wheeling works best on a stock with low volatility and high OI, what you mean is that it works best on a security with under-priced risk. I am sure there are actually many funds running strategies based on exploiting over-priced risk premiums. They just have no need to trade options on the open market since they can work with a market maker who can take the other side for them.
If you're selling options, you probably need to risk adjust your returns a bit more than what's common:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=377260
That's by Andrew Lo, big name in the area.
I'm sure you've also come across Taleb, who knows a thing or two about selling options.
https://alo.mit.edu/wp-content/uploads/2017/06/The-Statistic...
I have a hard time finding courses or books that cover how these instruments work in some depth.
Here we go anyway:
Hull: Futures, Options, and Other Derivatives
Natenberg. Don't recall the name, but this is maybe the closest to practical.
Paul Wilmott, Quantitative finance.
Taleb, Dynamic Hedging. Got a signed copy :)
Also I think it's smart to read about instruments that aren't options, ie don't just cut to the chase. Time value of money, futures, forwards, bonds, swaps, equities. Then vanilla options on all those things, then exotics.
is standard graduate stochastic calculus course material. An undergrad degree in math usually specializes in a certain track: algebra or analysis. The analysis background would be a closer fit as the material is focused on the continuous applications (not HFT) and likely have covered the introductory measure and probability theory material. The finance portion focuses on the arbitrage-risk neutral model that is at least a semester worth a material.
Interesting comment about the math. For my physics degree, a lot of times it was easier to think about things once I understood more of the math. I’ll see how it goes here.
While it is true that the upside is unlimited against a naked call (and the downside is 0 on a naked put), naked puts suffer from systemic risk that calls for all intents do not. Both are subject to news/events specific to the company in question, but the risk of the short call running away from you because the market had a +20% day are well, fleeting. On the other hand, unexpected economic news, politcal/military events, liquidity issues, etc can tank the entire market 10, 20, 30% and have numerous times. A rise of similar magnitude, to my knowledge, has only happened after market crashes (so you would then be alert to the upside risk).
What? If the stock goes lower than the strike price, the downside on a naked put is the difference between strike price and market price. You will be forced to take delivery of the stock at the strike price when you could have bought it for market price if you hadn't written the option.
It is not 0.
I suggest most retail to be short straddles against a core underlying position for yield enhancement. Yes, over a number of decades you will have something go against you, but under the current monetary and fiscal regimes, you should be hoping for the day that you can buy the dip or sell the rip via a systemic short vol overlay.
Selling straddles or strangles against a long position in a stock that you do like is reasonable play, but there needs to be a full understanding of how vol and time decay can effect the value of the entire position up to maturity and a recognition that nobody is getting assigned/called early excepting unique circumstances (ie, high dividend stocks)
For those reasons, I'd only suggest these types of trades to fairly well capitalized retail investors and those who have taken the time to gain a basic understanding of equity options and the use of margin. In proper hands, these can be very rewarding trade ideas/techniques.
So "people should buy a 20-30% dip" but should not be invested already? Because if they are, selling puts may not be a good idea.
That does not preculde already being invested as sitting on the sidelines waiting for such a move can be self defeating (the market rises 50% then drops 30% dramatically you would still be better off to have bought day one).
If you sell puts and are assigned, it may or may not happen at the optimal post crash price, but you will still be adding to your long at a much lower level. For instance, you sell a 30 put when the market is at 45. There is a great sell off, you are assigned when the underlying is trading at 25. You own at 30 less whatever premium you received, likely above 25. Certainly not the end of the world, but investor psychology is such that some people will be upset after the fact if they are paying more than current market price.
However, if you are not assigned you'll be pocketing those premiums as added income. But that is also another risk with naked puts - the market sells off but well before expiration and then rises again. You would miss the chance to buy unless you make the decision to take back the short puts at a loss and buy the cash at the now lower price. Again, you'll likely be paying net more than just having parked the cash and waited.
So naked puts may not be the best strategy if you know you absolutely positively will want to buy at a certain price, no matter what.
It may make sense if you had dry powder waiting for a correction. But at that point you are forced to buy (and as you say it may be at a higher price that the prevailing one in the market). You get premiums but you lose flexibility.
The problem is that they may be willing to own at a lower level today. But it may happen that when they have to own it the price is lower for a good reason.
The further towards out of the money you go the more it behaves like picking up pennies in front of a steamroller. But an interesting quirk of selling puts compared to calls is that the downside is limited. The stock can't go below 0.
The idea of using multiple symbols like SPY and TLT is to reduce the tail risk. But in the end there is still tail risk like for example in the crash of 2015. Making the strategy delta neutral with hedging could improve it but I never completed that part.
There is an interesting book with all the math by Euan Sinclair about option writing and how to minimize the risk if you are interested.
Covered calls
Naked puts
If you want to go heavy duty into it I recommend the Hull book (options, futures and other derivatives) but for your purposes the investopedia articles are enough.
Basically naked puts means you’re selling downside insurance so if the stock crashes you eat the loss. Covered calls mean you sell upside risk but have the stock so if it goes up you make a little.
If you have tail risk, then it means you have a decent chance of losing a lot more money than the typical variation. Your returns might look like +1.1, +0.9, +1.2 +1.05, -3. So your profit is pretty predictable with little variation, until suddenly you lose a lot of money.
Or you can learn stochastic calculus and end up in the same place once you realize half of all active traders do worse than the market, before fees.
But you're right in that if you don't have a passion for it, you'll never be able to truly outperform spy on a risk adjusted basis. However, if you do have the knowledge and the passion, I definitely think you can.
Investing is personal, and just holding spy doesn't fulfill everyone's objectives.
Here's an example of a strategy that outperforms spy in most cases: 1/3 of your portfolio goes to upro (3x leveraged spy) and 2/3s goes to a bond fund/etf. As long as the bond etf returns above the upro expense ratio (~1%), you will outperform. From my backtests, this strategy will earn you an extra 1-2% return a year, while also having a slightly higher risk adjusted returns.
I list the above as a great example because it's the kind of strategy that is great for a PA: easy to manage, doesn't require babysitting, and backed by solid academic research. When people think active vs passive, they think actively trading single stocks vs just holding an index. My point is that you can use some quant-lite strategies that tilt your portfolio to eek out a little return. You don't have to be trading everyday or even holding anything except ETFs.
This would make the stocks that have less weight in the index or stocks outside the index relatively cheap and obviously offer better returns.
Anyone disagree?
With respect to the stocks just outside the index, I think you could argue that they are probably undervalued and thus should offer better returns. This is what an academic would say. However, the actual reality could be a lot different: if returns are dominated by flows instead of fundamentals (like they are now), maybe going with the crowd is the best investment strategy. Or maybe not, I haven't done the research.
One thing that every market professional is worried about right now is just how dysfunctional valuations and returns seem to be in the modern era. Stocks seem to go up for no reason and returns have been disconnected from both fundamental and quantitative risk premia.
What I can say for sure is that we are in a period of intense change in the financial system. No one knows what the future of finance will look like, 10 years, 20, or 30 years out. Will crypto defi take over? Will traditional finance be disrupted? No one knows, but it is certainly an exciting time to work in the capital markets!
https://en.wikipedia.org/wiki/Fama–French_three-factor_model...
SMB stands for "Small [market capitalization] Minus Big" and measures the historic excess returns of small caps over big caps.
See for example https://www.msci.com/documents/1296102/1336482/Foundations_o...
What I mean is that I don't believe smb truly delivers superior risk adjusted returns. For example, I believe the betting against beta factor (BAB) does, while smb does not.
For what it’s worth, the value factor is not doing well recently either...
hmu
UPRO is up 426% (wow) $17.37-$74.01
and
^GSPC is up 192% (talk about a bull run) $1932-$3714
So with UPRO you would have had an average profit of 65.2% per year, and with SPY 18.4% per year. That's even better than x3 returns.
Plus you'd have the bond returns. Interesting idea.
lev = E(r) / Var(r)
So if the expected return is 10% and the expected volatility is 10%, optimal leverage to maximize geometric growth is 10x.
This of course is much too high and the risk of losing everything due to excessive kurtosis and downside skew is very high. Like the everything else in finance, fundamental sin of that formula is assumption of the log normality of returns.
However, is 3x too high for the long term? I dunno, but over long time periods, a pure 3x leveraged spy portfolio is going to outperform significantly. The problem is most people will be unable to weather the storm as you can easily lose half of your money in a week.
I wouldn't hold pure spy 3x and wouldn't exactly recommend it, but from a mathematical perspective it is a defensible (as in, you can make cogent arguments for it) long term investment.
On the other hand, I would probably recommend 1.5x lev or possibly even 2x lev to certain people.
As a quant, I approach these things like leverage from a mathematical perspective. It's important not to have an emotional reaction. There are very smart people running books that have 10x leverage but you would never be able to guess by looking at their volatility. It's all about the factor exposures, net delta, etc.
For example I've seen 15x leveraged delta neutral books that have absolutely insane Sharpe ratios (>15) and annualized volatility of less than 5%.
You don't define "long time periods" but the storm may be much longer than one week.
If you had invested with 3x leverage (daily rebalanced) in the S&P 500 anytime in 1999 or 2000 you would have been down over 90% in 2009 and you wouldn't have broken even until 2014 or 2016.
I'm not saying you don't have a point, but one would need to look at how it performs over longer periods with more varied market conditions to answer your question.
1 year: SPY +15% - UPRO +2%
3 years: SPY +37% - UPRO +33%
5 years: SPY +110% - UPRO +325%
Interesting that the last year performance was so bad - I think that stock market drop back in March and the general volatility / reshuffling since then must have hurt the leveraged strategy.
The idea is to get cheap borrowing by using a leverage ETF and then buying bonds such that the bond yield > cost of leverage.
I didn't say you would get those crazy returns - merely pointed out that you would have beat the S&P 500 over the last 5 years with the strategy outlined by the parent post.
How well it holds up over a time period that also includes bear markets is another question - you can't just look at a bull market and assume it's representative of all time.
If your passion is this sort of thing, by all means, go ahead.
But it's like running a homelab. Yes, you can get pretty decent "savings" (vs running in AWS/DO) but I can guarantee you, you will end up in the basement replugging ethernet cables trying to figure out which one is the bad one while your family and relatives are waiting upstairs, fairly bemused, for you to fix "the internet".
It's possible, but as a person with a life, unless it's your passion, I'd recommend just not. Do the financial equivalent of paying DigitalOcean 5 dollars a month: buy sp500 etfs and sit on them.
But maybe strategies involving puts will become more successful if we can convince more of the HN Bitcoin naysayers to sign up for LedgerX and put their money where their mouth is. :)