Category: Passive Income

How would you like to earn $80,000 a year trading options against your existing portfolio? That’s exactly what our guest, Karsten “Big ERN” Jeske, has achieved. In today’s episode, Jason talks with Karsten about his simple SPX options trading strategy. Particularly if you’re new to options, be sure to see the show notes below for definitions, associated blog posts, and more.

Show Notes

A reminder that neither we at Two Sides or FI, nor Karsten Jeske, are providing individual investment advice. Each of us has our own circumstances, risk tolerance, and risk capacity. Options trading, while potentially lucrative, is also potentially risky given the regular use of leverage, and is therefore best suited for experienced investors. We strongly recommend the use of simulated or “paper trading” accounts (you can create one free at Interactive Brokers and Charles Schwab, among others) to learn and test strategies. You may also benefit from consultation with financial professionals.

Karsten’s Option Strategy

• At the time this episode aired, Karsten had written eleven posts on options trading. His options landing page has links to each of these and is a great place to get started on his content after watching the episode.
• You won’t want to miss the historical information shared in his earlier posts, but Part 10 and Part 11 encompass Karsten’s current SPX options strategy which he discussed with Jason in the video.
• One of our favorite sections in his options series is “Aren’t you afraid of a repeat of October 1987?“, which can be found in Part 11. This contains Karsten’s analysis of daily price changes in the SPX in the context of volatility as measured by the VIX. Jason found it really useful in developing + testing his own risk model.
• Did you miss our earlier discussion with Karsten about sequence of returns risk and safe withdrawal rate? How about our episode featuring both Karsten and Fritz Gilbert (Retirement Manifesto) to talk about the bucket strategy? Among our most most popular episodes, these are must-view 2SFI content! For more details on the SWR Toolbox and how you can use this essential tool, check out our SWR landing page for tutorials and further information.

Options Trading Definitions

If you’re new to options, the specific terminology used can be dizzying. Before we dive into definitions, beginners may want to start with this short video introducing options trading.

Below you’ll find the definitions of options terms we used in this episode, courtesy of the CBOE’s glossary. For more information, including free introductory options courses, their material is hard to beat. If you prefer a canonical document that goes into much more detail than this list of definitions, be sure to check out the Options Disclosure Document (Characteristics and Risks of Standardized Options) put out by the Options Clearing Corporation (OCC). It’s lengthy but it’s really informative, and is required reading for anyone interested in trading options. Italicized terms used in definitions are also defined below.

• Call option: An option contract that gives the holder the right, but not the obligation, to buy an underlying asset at a certain price (strike) within a certain timeframe (on or before the expiration date). Buyers of call options pay a premium for this right. Conversely, sellers (also called writers) of call options have the obligation to sell the underlying asset at the strike price at any time prior to (American-style options) or on the expiration date (European-style options) of the contract. Sellers of call options receive a premium for writing the contract. Options contracts typically have a multiplier of 100 (i.e. one option contract = 100 shares of underlying).
• Put option: An option contract that gives the holder the right, but not the obligation, to sell an underlying asset at a certain price (strike) within a certain timeframe (expiration). Buyers of put options pay a premium for this right. Conversely, sellers (also called writers) of put options have the obligation to buy the underlying asset at the strike price at any time prior to (American-style options) or on the expiration date (European-style options) of the contract. Sellers of put options receive a premium for writing the contract.
• Underlying asset (or underlying): The asset, performance, or interest on which one has the right to buy or sell via the terms of a listed option contract. These are most often equity securities (like stock) or indexes (as in an index option).
• Index option: An option whose underlying asset is an index. An index option is typically cash-settled because the index itself is not tradable. Using the example in this episode, you can’t purchase the S&P 500 index but you can trade options on it via tickers like SPX. As we discussed, SPX is a cash-settled, European-style option.
• Strike price: The price at which an option holder may buy or sell the underlying security, as defined in the terms of the option contract. It is the price at which a call holder may exercise to buy the underlying asset or the put holder may exercise to sell the underlying asset.
• Exercise: To invoke the right granted under the terms of an option contract. Call holders exercise to buy the underlying asset, while put holders exercise to sell the underlying asset.
• Multiplier: The amount (most commonly 100x) specified in a cash-settled option contract by which the current underlying interest value is multiplied to arrive at the value required to be delivered upon valid exercise of the cash-settled option contract. This also applies to the premium of a contract – for example, when Karsten refers to ten cents of premium in the video, this is multiplied by 100; meaning that the options seller receives 100 x $0.10 or $10 of premium for writing that specific contract.
• Expiration date: The day when an option contract terminates. An options holder generally must indicate their desire to exercise, if they wish to do so, on or by the expiration date. American-style options may be exercised at any point prior to expiration, while European-style options may only be exercised on the expiration date.
• Premium: The amount paid (by the option buyer) or received (by the option seller) for an options contract.
• “The Greeks”: Measures used in options pricing models that determine the sensitivity of an option’s price to changes in certain variables, such as the price of the underlying asset, the time to expiration, among others. Two of the Greeks we mentioned in this episode are delta and theta. For an easily understandable introduction to the five most important Greeks, here’s a great video.
• Delta: The Greek which measures the change in the price of an option given a $1 change in the price of the underlying. For example, if an option has a delta of 0.40, then its price will theoretically move by $0.40 for every $1 change in the price of the underlying stock. A higher delta means a bigger price change. For call options, delta is between 0 and 1, and for put options, between -1 and 0.
• Theta: The Greek which measures the change in the option price as the time to expiration approaches. Theta is also known as time decay. For example, if an option has a theta of -0.50, then if all other things are held equal, the value of the option will decrease by $0.50 each day. For more information and examples, see this video.
• Out-of-the-money (OTM): A term describing an option that has no intrinsic value. A call option is OTM if the underlying asset price/value is below the strike price of the call, while a put option is OTM if the underlying asset price/value is higher than the strike price of the put. The opposite of these two statements defines an in-the-money (ITM) option.
• Intrinsic value: The value of an option if it was to expire immediately. For call options, this is the difference between the price/value of the underlying and the strike price; if that difference is positive, the call option has intrinsic value, otherwise it is zero. For put options, it is the difference between the strike price and the price/value of the underlying asset; if that difference is positive, the put option has intrinsic value, otherwise it is zero.
• Volatility: A measure of the amount by which an underlying asset is expected to fluctuate in a given period of time. Generally, volatility is measured by the annual standard deviation of the daily price changes in the asset. There are two types of volatility: historical and implied. The former is calculated using past, or historical prices of the stock. Implied volatility (or IV) is a forward-looking measure that is calculated using an option pricing model and the current option price as an input to “imply” the future volatility of the stock (we didn’t discuss it in the video, but the Greek, “vega,” describes how much the option price changes relative to changes in IV).
• VIX: This is is the ticker symbol and the popular name for the Chicago Board Options Exchange’s (CBOE) Volatility Index, a measure of the stock market’s expectation of volatility based on S&P 500 index options. Some investors use the so-called “Rule of 16” to estimate the expected daily range of the S&P 500 based on the VIX.
• Days to Expiration (DTE): This term refers to how many days from the present until a given option contract expires. If you trade it the day before expiry, an option contract is said to be 1 DTE. An options contract traded on the day of expiration is termed 0 DTE. Both of these contract durations were discussed in this episode.
• Margin: Cash, cash equivalents, and securities that an investor must deposit into a brokerage account as collateral in order to use borrowed funds from their broker to trade options. In the strategy discussed in this episode, margin refers to the amount of assets the investor needs to hold to demonstrate their ability to cover potential losses.
• Naked (or Uncovered) vs. Covered: Refers to whether the investor currently possesses (covered) or doesn’t possess (naked) an offsetting position in the underlying asset. Depending on the level of options trading permissions one has with their brokerage, an investor may or may not be able to trade naked options given their loss potential.
• Stop orders: This is an instruction to a brokerage to buy or sell a security, ETF, options contract, etc. when that asset reaches a specific price, known as the stop price. When the stop price is reached, the stop order becomes a market order and is usually executed at the next available market price. When a stop order executes, this is commonly referred to as “being stopped out”.
• Notional value: The value of the underlying asset at the current price. For an options contract, the notional value is the number of units of the underlying asset covered by the current price of the underlying asset. For example, if the S&P is 5500, the notional value of an SPX options contract (100x multiplier) is $5500 x 100 or $550,000.

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