Here's how to try it out:
- If you don't already have one, open a futures trading account. Many brokerages provide this; my favorite is T.D. Ameritrade with their ThinkorSwim software. Note: this can't be an IRA if you're using T.D. Ameritrade; they don't allow futures options trading in their IRAs, and that's an integral part of this strategy. (Some less popular brokerages do allow this; let me know if you've tried one that you like.)
- Fund the account! All brokerages will have several ways for you to do this; you could even write a check. Wire transfers will typically get you trading in minimal time, if you're in a hurry.
- Pick a direction: short or long! Right now the market is near its all-time high, so short is probably the right direction. In this case you want to sell short 1 /ES futures contract (to start):
- Next sell 1 /ES put, between 7 and 14 days from expiration:In this case you get $662.50 in credit for this trade, 9 days from expiration.
- The /ES futures gains or loses $50 per point. In this case, we're short, so if the market goes up from here we lose $50 for each point or if it goes down we gain $50. In either case we get to collect that $662.50 in credit for selling the covered put.
- Hold the option position until just before expiration, when it has collapsed within 50 cents to 1 dollar of its intrinsic value. (If it's out of the money, its intrinsic value is 0, so buy it back for no more than $1.) The calculation is a little more complicated if the put is in the money, but the principal is the same. If you sell the 2080 put and the market is at 2076 near expiration, the put's value should be getting near $4 so don't buy it back for anything more than $5.
- Do this every Friday, forever, collecting between $500 and $650 (sometimes more) for the 7 days of the trade.
The graphics here are from ThinkOrSwim's OnDemand Virtual trading platform. You can experiment with this or with one of its counterparts at other brokerages, but don't mistake it for real trading. Personally I find paper trading worthless except as a vehicle for showing examples like this. Your mileage may differ, but I think just starting as small as possible: 1 /ES contract and 1 covered put or call, will give you the flavor of the real thing at minimal risk.
Analysis of the profit-loss potential and the virtue of being short
Basically, three things can happen:
- The market can fail to move at all from where you put the trade on. The put expires worthless, in this case giving you a gain of $662.50 for the week and you sell another one for the next week.
- The market moves against you, in this case going up when you were short. You gain $662.50 on the sale of the put but lose $50 for every point the market goes up from where you sold the futures contract. So in this case you can cover 13.25 points before you start to lose money.
- The market moves in the direction you expect. You make the $662.50 you got on the put, plus $50 point between the sale price at the time you put the trade on and the strike price of the put. In this case, the market was 2088 and you sold the 2085 put, so that's $150 plus $662.50 or $812.50. You lose $1 on the put from that point for every $1 you gain on the futures contract, so your profit graph flattens out at $812.50 for this week.
The same principles apply if you're long (i.e. you bought an /ES future and sold a covered call against it), with two exceptions:
- The puts pay better: fear is overpriced in the marketplace so you get paid better for selling them than you do calls.
- The market never crashes up ... it can grind slowly up for long periods, but being short you're protected from a crash. You make a bit more money that week, that's all.
Scaling up
Say you've been doing this trade with 1 contract and one covered put or call for some weeks and you understand the nuances. You could then go to 3 or 5 or 10 or 20 contracts; I'd suggest no more than 1/2 of the buying power in your account, to cover moves against you. Each contract takes roughly $5000 in buying power, so if you have $100000 in your account you could reasonably use a size of 9 or 10 contracts and covered options.
At size 10, that makes the $500 to $650 into $5000 to $6500 ... and $50 per point into $500 per point. You could reasonably take 1/2 the credit as income every week ...
When to Change Direction
If you've been short for a while and watched the market go down 10% within a few weeks ... shouldn't you then go long? Maybe ... you can use your intuition on this or use technical analysis or ... you can just watch TastyTrade and do whatever Tom Sosnoff is doing. He's mostly short-oriented but will go long when the market has "capitulated" as in late February this year ...
Happy trading ... Comments?
