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Rinse and Repeat

Rinsd and Repeat is an Income Strategy. If you are not familiar with income strategies, please review what they are before proceeding.

Rinse and Repeat is a short option income strategy that seeks to generate consistent income in up and down markets by selling options (both calls and puts) on a regular basis with various risk levels. As with any option strategy, the nuances are the key to success.

Short option strategies abound. The fundamental mechanics are straightforward if not simple to the newly intiated.
One basically sells calls or puts against underlying assets, cash, or naked. Butcher’s Row does not re-invent the mechanics; however over time an approach to the strategy has evolved that is unique to Butcher’s Row.

This methodology was originally designed to replace salaried income. It has the potential to generate between 1% and 3% (or more) of invested capital per week; though much depends on the discipline of the investor/trader. Therefore, commitment to the strategy with a nominal portfolio of $100k can generate between $1,000 and $3,000 per week in income * *BEFORE TAXES**. Since this is income, it is taxable at the ordinary income rate.

Capital gains are possible with this strategy, but not the objective of the strategy. As we shall see, focusing on capital gains defeats the ability to generate consistent income.

As with all strategies in Butcher’s Row, it is designed to be part of a portfolio of strategies that work together to maximize total returns. And as with all strategies within the methodology, it is designed to be diversified in every way.

A set of tools within the Brokenstock Application support the strategy.

Philosophy

It is well known that premium yields are most advantageous at the money (ATM) and that for some symbols the weekly premium yield 7 days out can be 3% or more. Why more traders/investors do not use this strategy is likely due to several factors including:

Lack of understanding of options trading mechanics
Fear of missing out on large stock price swings
Getting stuck in long dated rolls and not knowledgeable on exit techniques
Lack of accessibility of tools to understand and manage profits and exit conditions
Lack of appropriate mindset

Mindset

In fact, it is this author’s POV that short option strategies fail mostly due to the last factor, the mindset of the trader/investor. This is true of many if not all strategies, but when stock traders get into options it is compounded. Retail stock investors tend to be Buy and Hold investors, and this mindset is not appropriate. It may seem counterintuitive that holding a profitable short option to expiration isn’t always the best strategy, and hopefully the reader will understand why as they read on.

Rinse and Repeat is an income strategy as it generates income, but it is really a Lending Strategy. The trader/investor needs to look at their Rinse and Repeat positions as loans to the market in the form of stock or cash in return for a premium. Only in thinking about the strategy in this way can the trader/investor be successful and reap the accumulated 1% to 3%+ per week.

In terms of being a Lending Strategy, the reserved cash or stock is a principle, and the option premium is the lending yield. It differs from a conventional loan in that the principle can be variable, but the yield is fixed.
For short calls, the principle is variable because the value of the owned stock can change, while for short puts the principle is variable if assignment leads to stock ownership.

Once the trader/investor has transitioned to thinking like a lender, the future value of the underlying principle is important only in terms of not loosing capital. The focus is on the premium. Of course, there can be
underlying capital appreciation (and depreciation) - and if the stock takes on some momentum the trader/investor may miss out on larger gains or incur losses - at least on paper. But again, the focus is on lending.

If the focus is on lending, then the measurement of it is the premium received as expressed by annualized yield.
Why annualized yield? Because if one can repeatedly make 2% per week, that’s 104% per year; if one is content with 2% over an unspecified timeframe, say 3 months, then that’s only 36% per year if easily repeatable. Said another way, $200 premium in one week over $10,000 invested is 2% for the week. It seems rather small compared to say $1000 over 3 months on $10,000, which is 10% for 3 months. The latter is market beating; so is the former. The difference is the former will yield 104% per year if repeatable, while the latter yields only 40% per year. The potential as measured by annualized yield should be clear, and is what matters.

Therefore, in Rinse and Repeat, the trader/investor thinks of themselves as a lender, and focuses the Rinse and Repeat portfolio capital on generating 1% to 3% per week.

Occasionally though, either greed, fear, common sense or analysis will lead the trader/investor to deviate from lending, and they will decisions based on stock price movement. There are times when this is acceptable, and we have a numerical way of helping make those decisions.

It is acceptable because if we can increase the margin of safety (reduced cost basis) on principle and still continue to leverage the stock as a periodic lending vehicle, we will have greatly reduced risk.

It is also acceptable because stock price may have taken a dip with normal market dynamics, and the trader/investor needs to risk a lower strike price to capture the premium yield, one that could potentially be below cost basis.
This is part of the strategy, but it does not mean that one will let oneself be assigned at a loss.

** Tools **

The Rinse and Repeat strategy requires tools that are not commonly available, certainly not with brokers where their positions are held.

Generally speaking, brokers provide only the profitability of the current option position; if one rolls options which is frequent with Rinse and Repeat, actual profitability (and annualized yield) becomes obscure quickly.

The first tool that the successful Rinse and Repeat trader/investor needs is an overall probability tool of a complex trade that may include underlying stock, inner trades, dividends, short calls and short options. Typically, we consider a trade started for a given underlying in a portfolio when the initial opening purchase whether an equity purchased, shorted (going long or short) or an option bought/sold to open. The trade is considered closed only when all positions are closed; inner trades occur when positions are added, closed, rolled, assigned or expired or when a unary event such as dividends occurs. But the overall trade stays open until the last equity quantity or option is closed. Thinking about “trades” in this way is essential to Rinse and Repeat.

But how does one measure the overall profitability of the “trade” or any “inner trade”? One can use the Brokenstock Application or track necessary transactions in a spreadsheet. We recommend the former, as the latter sounds simple but gets complicated very quickly. Try it…

Another tool that is essential is a market scanner that will find options with the yield desired. It is a casual observation that including ETFs, there are a limited number of equities that have, say weekly options with 1% or more premium yield for a given market cap and price range. There may be adequate option scanners out there, but again, Brokenstock offers such a scanner for the very purpose of this strategy.

Since this is an income strategy, tools that measure overall income per unit time (weeks preferably, but also months, quarters and years) are needed to determine the regular income generated by the strategy. Again, Brokenstock provides such tools, both raw income but also adjusted for overall position closure (Sometimes, we make a decision to close a position which can be profitable overall, but which may appear as an income loss - we want to exlude that from regular income calculations. For example this can happen when one has massive capital gains, but for some reason has an overall loss on option positions. The combined yield may be profitable, but the closure will contribute negatively to income when that is not the intent).

Another tools that is useful, and provided by the Brokenstock Application, is a calendar of dollar amounts to be expired, which will call the Expiration Ladder. This is useful to spread effective principle over weeks into the future, another form of diversification. One does not want their short options obligations to all expire in the next week, or on any given week, but rather over a period of time.

Prerequisites

The prerequisites identified as a whole for the Butcher’s Row methodology is understood to be in place. In addition, this methodology has additional prerequisites.

Options Trading Basics

This is a short options strategy. Therefore, within this strategy the trader/investor will be writing calls, selling puts, rolling options for credit (and possibly, rarely for debits), having options expire, being assigned and at times closing entire positions.

Therefore, it is imperative that the trader/investor understand the mechanics of options trading insofar as the above is concerned. Advanced options such as spreads/multi-legged options are not used in this strategy, so the specifics of advanced option strategies are not required.

(In some future edition, the required option trading basics will be explained here []).

The remaining part of this strategy uses the above terms fluently. Know them.

Options Trading Level (Brokerage)

Your brokerage will undoubtedly have a level system for options trading. Typically, this strategy requires at least Level 2 options trading, which allows for covered calls. Some brokerages may require Level 3 or higher for selling puts, so check with your brokerage to ensure you have the appropriate level of options trading enabled. The early options levels are usually granted by attesting to a certain amount of experience as well as a certain level or risk tolerance. This strategy should not require the highest level of options trading, where brokerages usually have stipulations.

If you cannot be granted the ability to short puts, you can still execute this strategy with covered calls only.
However, there are instances where selling puts is advantageous, and in the extreme, the only alternative.

Generally speaking, selling puts does not immediately put the trader/investor at risk of a wash sale on the underlying, since until assignment no underlying is purchased. In some market situations particularly bearish ones, it is psychologically advantageous to sell puts; also the premium on selling puts may be larger in some circumstances. However, in moderately bullish or neutral market, writing calls tends to have higher premiums.

For the purposes of income, there is little psychological difference between selling puts and writing calls near the money. One tends to go with the better yield alternative. On the one hand (unless your brokerage allows naked puts on margin), selling puts will reserve cash equal to the strike price of the put, which may limit the amount of capital available for other trades. On the other hand, writing calls will require ownership of the underlying asset, which may also limit capital availability.

Strategy Execution Overview

In this strategy, one seeks to sell options ATM or close to it, in near dated expirations, typically on weeklies, against quality assets. At steady state, the week begins with expirations and assignments from the prior week, plus any excess cash, as well as existing positions that either did not expire/get assigne the prior week or were rolled forward. Depending on market conditions the trader/investor sells options (sells puts, writes calls, or sells covered calls) throughout the week and possibly rolls positions forward. Excess cash is used to write new calls or sell puts, while prior expirations have new calls sold against the underlying.

Care must be taken based on market and underlying price direction, especially with rolling. There are pitfalls documented later that require special handling to exit profitably or at least at minimal loss (Butcher’s Row rarely accepts a loss).

It is critical that one puts aside the usual investor’s mindset with this strategy. To think like an investor here is to fail. Therefore, we cover the philosophy of this strategy in detail below.

Philosophy

Butcher’s Row strategies are each based on a certain philosophy. The Rinse and Repeat strategy is based on lending. That’s right, it is not trading or investing, but lending. Until the portfolio owner understands this, they will struggle with making this strategy consistently successful.

A banker loans a fixed amount for a fixed or variable rate for a period of time. The loan can usually be repaid at any time, eliminating some of the yield.

In the Rinse and Repeat strategy, the philosophy is that the portfolio owner is lending a principle to the market for a premium or yield. The difference with the banker is that the principle here has a variable value, and the term of the loan is determined by the expiration date. It can of course be paid back through assignment or closed at any time by returning some of the premium (bying back the option).

Why is this philosophy so important? Because until the portfolio owner understands that they are lending and not investing,they will make various decisions like an investor versus a lender. A lender does not worry about missing out on future principle growth, they are instead focused on the yield for the loan.

For example, it is common for covered call writers to be concerned about missing out on future stock price appreciation. When they realize that they may be assigned or that they will miss out on significant capital appreciation, traders often decide to buy back the option at a loss or roll it blindly forward and up, not fully taking in the consequences.

A lender on the other hand, is not primarily focused on capital appreciation, but rather on the yield of the loan.
The primary job is to secure the yield that was initially expected. Thus, the lender will tend to be more patient and consider all factors before making a decision to close out the position, roll it forward or take assignment.
This author can guarantee that often, it is far more lucrative to accept assignment on a Friday and perform a new buy-write on the following Monday than it is to roll the option forward and up.

So…the philosophy here is to think like a lender. Just as one cannot time the top on momentum strategies, one cannot know what the future holds. Rinse and Repeat is a strategy that is designed to generate consistent income over time and the best way is to think of the strategy as a lending strategy rather than an investing strategy.

Selection of Underlying Assets

Since this is an income strategy, careful selection of the underlying assets is important. Quality Assets should be selected for the time frames desired. Generally speaking a Quality Asset is an asset over a specific timeframe where the likelihood of massive losses is a minimum. For specific criteria, see the section on Quality Assets.

Additional criteria exist on top of Quality Assets for the Rinse and Repeat strategy. The underlying asset should have a high degree of liquidity, such that opening and closing positions, including options can be made at the median price or better. The option chain contains weeklies as the strategy operates on a weekly basis, but at times monthlies may be used for the Calendar Diversification or because there is an ideal entry point for a monthly.

Once these criteria have been established, sufficient volatility is needed (or at least option pricing) such that ATM premium yields 1 week out is a minimum of 1%, but more often at least 1.5% or higher on short calls or short puts. Remember, premium yields is the premium divided by the purchase price exclusive of any capital gains.