An Extreme–Income Portfolio

This strategy idea does not aim to earn high dividend income, but instead uses an active option-selling strategy to generate large cash flows around a stock position. It is based on a previous post that explores the idea of selling the most expensive options the market offers (that post also describes the basic premise of harvesting a volatility risk premium). A live test of the idea over a few months has quickly led to the adjustments and moderations I describe here: By buying a stock and selling out-of-the-money put and call options against the position (a covered short strangle), I aim to build a portfolio of stocks that earns a premium of around 10% monthly (over 4-6 weeks, as long as the underlying stock trades in a range of around +/- 5-15% – though larger moves will reduce the option premium I initially received).

The Conundrum of investing in individual stocks

I have never been able to find an edge in traditional ways of individual stock selection. On the contrary, because a majority of stocks underperforms the index (the index performance is largely carried by a small number of stocks that perform very well), the base-rate expectation in selecting stocks is actually negative.

So, how to select individual stocks to invest in?

For the purpose of this stock portfolio, I don’t actually care how any individual stock performs – I even anticipate underperformance as the most likely outcome. Instead, I use return characteristics that are knowable in advance to select my stocks: I know the premium that is paid for options when I buy the stock. The only thing I really care about is the richness of option premia – and, because these are high, I expect to outperform over time, while my stocks fluctuate across a wide range (volatility is an asset not a drag in this case).

Screening out the very riskiest stocks

The highest risks such a speculative portfolio faces are stocks going bankrupt or facing extreme event risks that lead to overnight gaps of 50% + (e.g. biotech stocks facing FDA decisions or stocks with big earnings surprises). During my test phase in the beginning of the year, I saw numerous example of biotech stocks gapping (the majority of them down 60-80%), a crisis that drove several bank stocks into bankruptcy mere days after they appeared on my screen of options with the highest implied volatility, and so on.

The stocks with the very highest option premia are really, really risky.

While such a high-risk strategy is still likely to work over time, because option premia should over-compensate for the risks, I would prefer to create a curated portfolio that I can write options on again and again with fewer outliers and more moderate changes in its composition. Therefore, I adjusted my options screener to target a second tier of highly risky stocks (defined by options with high implied volatility IV) that are fairly well known and established: A selection of Blue Chip Speculative Stocks and High Quality MEME Stocks (somewhat of an oxymoron).

I found a pretty nifty option screener at Market Chameleon that allows to sort options by implied straddle premium (a straddle is the same as a strangle, but uses at-the-money options) for free, but a subscription makes the work easier by filtering the screen: I look for stocks above a $10 Billion market cap that are relatively well known (availability of weekly options is a great tell and very convenient for running the strategy, as are stock prices between $10-60), filtering for options with less than 40 days to expiration. An implied straddle premium above 17% will usually lead to a strangle with options that are 5-10% out of the money yielding at least 10% of the current stock price in premium (by selling both calls and puts equal to the amount of stock I hold divided by 100).

A prominent example

The most well-known stock that makes the screen on April 10, 2023 is Tesla TSLA trading at $185, with an implied ATM volatility of 55 and an implied straddle premium of 17,2% for the May 26, 2023 expiration (35 trading days away). We can choose the out-of-the-money strikes 170 put (-8% OTM) and 195 call (5% OTM) for a strangle yielding 11% ($2100) of Tesla’s current price ($18500 for a 100 lot).

TSLA option chain for May 26, 2023 (35 trading days). For a strangle yielding 11% the OTM strikes 170 put and 195 call are chosen. Market Chameleon
DateTickerPricePositionExpirationCall StrikeCall PriceOTM %Put StrikePut PriceOTM %# OptionsPremiumPremium %
2023-04-06TSLA18518500May 26195125%17098%1210011%
These are actual prices the options traded at around the market close on April 6.

The main problem for a diversified portfolio is probably the stock’s high price, but there are plenty of alternatives currently (e.g. RBLX, COIN, SQ, DASH, ENPH, SHOP, SNOW, AI, AFRM, PACW…) to put together a portfolio of 10-15 stocks – albeit some care is needed to find names that are not super-highly correlated.

Stock price agnostic

The key idea is: I don’t care where my stocks trade, I just want to earn the option strangle premium month after month for as long as it is at least 10% (at a premium drop to 8-9% I will replace that stock with a new candidate). This sounds easy, but there are risks involved (as with any strategy), and lots of factors can diminish the premium earned or turn it in to a loss by expiration – this will effectively cut the premium earned by expiration on average to a lower and more realistic percentage for volatile stocks.

What can happen and how to deal with it:

In general, I expect my stocks to fluctuate all over the place and I keep a cash reserve to take put assignment during deep market pullbacks in expectation of an eventual recovery. For prominent stocks, like Tesla, I anticipate long-term survival with wide trading ranges (+100% / -50% ranges lasting years are the historic norm) interspersed by large price jumps into new ranges.

a) Non-event: Stock trades between the strikes on May 26: Both options expire worthless, we earn 11% premium and write new options, while the stock has gained / lost 5-8% at a maximum. This is the optimal outcome for a strangle position creating a 10%+ income stream every 4-6 weeks.

b) Strong move: Stock rises or falls above / below options strike, but doesn’t reach the break-even threshold on May 26 (break-even = strike of in-the-money option +/- the entire premium earned = $21 x 100 in our Tesla example). High options prices imply that such strong moves are quite likely to occur.
We earn the premium minus the distance from the ITM option’s strike (a 0-10% yield). We close the option the day before expiration to avoid assignment and write new options around the new stock price.
It is preferable, if the stock has gained significantly, as we could exit the position at an additional profit at any time and the new absolute $ premium rises. In this case we will earn the full put premium, but the call premium is reduced above the call strike (call break-even is at call strike + call premium = $207 for TSLA, above which the call option will lose money – however, this is fully compensated by the stock’s rise).
A falling stock is a moderate risk, as long as we do not have to sell the position. We will earn the full call premium, but the put premium is reduced below the put strike (put break-even is at put strike minus put premium = TSLA @ $161, but to that we need to add an unrealized loss in the stock). A new strangle will earn less, because the stock price is now lower (we aim for 10%+ on the new stock price).

c) Highly volatile move: Stocks rise or fall exceeds break-even threshold (the options position will post a loss at expiration, because the loss of one option exceeds the $2100 premium we got paid for both).
For a rising stock the loss on the short call option will be fully compensated by the rise in the stock’s price. We close the ITM call the day before expiration to avoid assignment and write new options around the new stock price earning a higher $ premium (10%+ of the new stock price). There is little risk in this scenario, but the loss on the call option will turn the premium we aimed to earn into a loss and thereby cap the unrealized gains on the stock.

The main risk for the strategy is a significant drop in the stock’s price. For a stock falling below break-even (TSLA below $149) we take a loss on our options position, but simply write new options around the new stock price (albeit at a lower $ premium and with an additional, unrealized loss for the stock itself remaining on our book). If the drop exceeds 40% from my original entry, I plan on taking the put assignment to adjust my position size (the stock position will be deep underwater). If not, then we close the ITM put the day before expiration to avoid assignment.

In case of a tail event (bankruptcy or a stock collapse of 75% or worse), I plan to take the loss, close out the entire position, and move on.
Conversely, if a stock more than doubles, we can adjust its position size by selling half the position for our cash reserve.

With enough patience we can go through major drawdowns for our stocks, while earning a high premium all the way. Over time this will reduce our cost-base to zero. Because we re-balance position sizes regularly, a moderate comeback for the stock will quickly end up in the green – the strategy will work over the long run, provided the stock survives and partially recovers from drawdowns at some point.

For more practical details on running a holistic investment / trading portfolio, and to support my research consider subscribing to my weekly premium report. Thank you!

A big bear market in speculative stocks

The 2021 to 2022 bear market hit speculative stocks hard, but also drove option premia up. Analogies to other boom and bust cycles lead to an anticipation of a consolidation period that could last for years, before a slow recovery of the survivors. I would consider this an ideal environment for the strategy, as we are already far below speculative highs with signs of significant stabilization. Should we face a long time during which the speculative names of the last cycle essentially go nowhere, the strangle strategy will help to outperform significantly. While some stocks will not make it, others will thrive and a focus on the option generated income will help to put the probabilities for a positive outcome in our favor.

I plan to add such a portfolio as an additional sleeve to my trading allocation (which is the smaller part of my overall portfolio of strategies). I expect to make further adjustments to strategy details with live-trading experience.

Please do your own due diligence before jumping in! This is merely a common sense estimate of the viability of such a strategy. We would now need to collect real world data. The only realistic way to do that (that I can see) is to use real trial trades with actual execution prices, because historical options data tends to be unreliable.

Good luck with your trading, and thank you for reading!


This is not financial advice.
These are my own views, as I may implement them in my own portfolio.
Please do your own due diligence!

Browse Recent Blog Posts

If you like what you are reading, please consider subscribing – thank you! Your support is greatly appreciated.

One comment

Leave a Reply