Beat the S&P 500?
Recently I’ve been publishing information on cash secured puts and covered calls and how to use them in your investing strategy. Do they really work though? I’ve started selling them and really like how they work. I wonder though, it is worth the effort? I mean, I really like the idea of income every week, but can this strategy beat the S&P 500? If it can’t, then why not just send it to an index fund and let it ride. It would save a lot of work right? So whY aM I Doing This? Well, I want to find out using real money if it’s possible, I want to document everything I do to help others learn and I would like to make some income along the journey. Consequently, I opened up an account with $6,000 to use for this test of selling cash secured puts and covered calls. The goal is to track from the time it starts, documenting all of the trades, income and expenses moving forward to see how well I do compared to the S&P 500 Index. Keep in mind, I’m not an investment advisor, or professional trader, just a guy who learned how to trade this strategy, sometimes referred to as an options wheel strategy. So take this for what it is, just an educational or entertaining (if you’re a money nerd) series of posts to document my history in the challenge to beat the S&P 500.
The Starting Point.
I’m starting this on June 1, 2023. I’ll be tracking against an S&P 500 Index ETF, the Vanguard S&P 500 ETF, VOO. I’ll log the number of shares that $6,000 would buy including fractional shares since you can do that now and we’ll go from there. If dividends are paid I’ll reinvest them into more shares at the opening price on the day the dividend is paid. Hopefully that will keep the process standardized so there won’t be questions about the price on the day of the activity.
Here’s a quick screen shot from June 1. You’ll see I’m already off as I made the deposit a day ago and actually earned a few cents interest and I sold a put on Coinbase. The interest is so small it shouldn’t really matter in the long run. I sold the cash secured put just before taking the screen shot. I wanted to get started right away and on June 1 sold the put that expired June 2 for just over 1%. Good start, right?
Here’s a record of the first few transactions:
For the options, I just use the cash available. I know I could possibly leverage since there is margin available, but I’ll be sticking to just using the cash in the account for puts and only the stock I own for the calls.
As the process goes along, I’ll be updating the results as well as posting about the trades I’m making. Here are some of my thoughts as I get started. Right off the bat it may appear that the advantage goes to the Vanguard VOO ETF account. One hundred percent of the funds will be considered invested at all times. The options account, on the other hand, will only invest based on the strike prices of the underlying securities. I guess If I could find the right combination I could be 100% invested there too, but there will be a lot of factors, like premium, volatility, share price, time to expiration and whatever else comes up. Hey, even a vacation could hinder the performance if I happen to be gone when it’s time to sell covered calls or cash secured puts again and am not available to do so.
To begin with I’ll be using what is called a wheel strategy. This is basically starting off by selling cash secured puts on a stock until it gets assigned to you, then selling covered calls until it gets assigned to the buyer. Once this happens you sell puts again. I’ll also be doing this on a week by week basis to start, with the goal of earning at or over 1% per week. Sounds pretty high, right? Maybe, but I’ve seen weeks where a 3% total premium versus the funds allocated was eclipsed, so we’ll go with 1%. With a 1% per week goal that would mean the account would increase by about 50% in a year. This seems near impossible, but there have been years when sectors of the market have done that, so why not. I’m sure there will be times I’m just working for a positive return for the year as well.
I’ve heard the average annual return of the S&P 500 is over 10% since inception. In most cases that is a great annual return, especially if you could sustain it for decades. In looking it up I found that Investopedia reported the S&P 500 index has returned a historic annualized average return of around 11.88% since its 1957 inception through the end of 2021, so that’s the goal to beat.
Tax Considerations
One of the drawbacks of selling calls and puts is the tax situation that it could cause compared to investing in exchange traded in index funds. For example, if I were to invest the funds in an index ETF and leave them there, I would only incur taxes when dividends or other distributions were paid and then when I eventually sold the ETF. On the other hand, each time I sell a call or put it will be a taxable event, meaning I’d have to pay tax on the premiums received. Not that great of a deal if I end up paying around 20% or whatever my income tax rate is on all of the income.
To alleviate the tax burden along with trying to keep track of it all, I opened the account as a Roth IRA. In a Roth IRA I don’t have to pay taxes. I wrote an article about Roth IRAs with all the details about how they work. This way if everything works out, when I am ready to take funds from the account there won’t be any taxes due. Of course there are some rules there about retirement age and contributions, but my goal is to not need to take the funds out for a long time, especially if I want a long history of comparison in the results.
Diversification Risk
As we’ve already seen with the first trade, there’s not much diversification if I choose to sell options on a stock that’s around $60. It takes the entire portfolio. If you are starting with a relatively small amount you have to be ok with this. For example if you were starting with $1,000 with the goal of using the wheel strategy to sell put and calls, you’d be pretty limited. To start the stock would have to be around $10 or less, just to get started. This strategy, especially the way I just started, is not diversified. It’s something I’ll have to consider if and when the account starts to grow.
The risk is high. What if the one stock I sell a put on tanks and I get put the stock. How long would it take to make it back to even selling calls? Hopefully it doesn’t happen but it’s definitely a possibility.
Conversely, investing my $6,000 in the Vanguard S&P 500 ETF, ticker VOO, would essentially be like buying shares in all 500 companies that make up the index. Compared to investing in the wheel strategy, this is way more diversified. On a side note, I would never recommend that you start a wheel strategy with 100% of your funds, so keep that in mind. Way to risky!
Compounding Effect Thoughts
Funds invested in the S&P 500 ETF will have an automatic compounding effect. All distributions from VOO whether they be dividends or any other distribution from the fund will be automatically reinvested at the opening price on the day of the transaction, giving this fund an advantage over the Options fund.
The Options Account, on the other hand can’t always redeploy the funds. There will be interest earned on the cash, but that will be relatively small. Here’s the disadvantage, let’s say in a perfect world I found a stock or stocks that totaled $60 and could sell weekly puts on them. Let’s also say for example, I collected the premium of 1%, or $60.00 in this case. Each options contract is for 100 shares so I could only sell one in this case since $60 per share times 100 shares would be $6,000.00 and that’s without any commissions or fees. I’ll have to remember that when selling options. So I need to have $6,000 to be able to sell the put so if it gets assigned I have enough to buy the shares.
Sounds great, I’ll earn the 1% and the account will be worth $6,060. The problem is that the next week, I can still only sell one put for $60 again, meaning the other $60 isn’t working for me yet. It may take some time before I could sell another put contract unless I choose a different stock and different strike prices. Another thing to consider when selling options when comparing to investing and letting it grow, no automation.
Reporting
I’ll be checking in from time to time with how trades are going, but the real report will come out at the end of each month. I’ll get a copy of my brokerage statement and a screenshot of the closing price of the ETF to compare with as well as keep an historical spreadsheet to review where I stand at the end of each period. Win or lose, I’ll learn some good lessons along the way. Let’s see how it goes!
Month 1 Results – June 2023 Cash Secured Puts vs S&P 500 Challenge
Month 2 Results – July 2023 Cash Secured Puts vs S&P 500 Challenge
Lastly, I value input. If there is something I’m missing in the thought process or tracking let me know. I’m always looking for ways to improve.