Today we look at selling puts for income.
We discuss the procedure, the expected returns and the risks.
In a world where global returns are zero or even negative, the search for income is becoming more common.
For investors who are about to retire and are looking for steady sources of income, this can be a challenge.
In the fixed income space, this can result in portfolios chasing any return they can get, further depressing returns on riskier assets.
The result is not pretty for an investor looking for income.
Still there are many income generating strategies Use options.
This article examines the strategy of selling puts as an income-based strategy.
ON Put option gives an investor the right to sell a security at a certain price before a certain date.
As a seller, we sell this right to someone. In return, we collect a premium.
If the security remains above the strike price, the put seller will collect the entire premium.
Nonetheless, if the security falls below the strike price, the investor will suffer losses as shown below.
In this example with the SPY trading at $ 423.72, we sold the $ 420 monthly put option and received $ 5 in credit for it.
In this case, we make money in 3 ways:
- If the stock goes up, we’ll keep the entire $ 5 loan.
- If the stock stays flat or goes slightly down (still above our 420 strike) we will also collect $ 5
- The stock is moving down but staying above $ 415, we’re taking a portion of the $ 5 premium.
Notice how we make money in most of the scenarios.
Selling puts translates into constant, hassle-free income 90% of the time.
It’s the other 10% that has the red arrow that we need to worry about.
More to Tail risk and risk management are coming.
In terms of our exposure to Greece, selling puts is long delta, long theta, shortly gamma, and short vega.
Whenever we place a trade, it is important to understand why the trade is supposed to make money.
In the case of the Sell puts Trading has a positive expectation as it provides protection to the person holding the security and limits their losses.
The best way to imagine a put seller is like an insurance provider. In most cases, insurers simply collect the premium from their customers.
Nevertheless, in the event of a disaster, they are often hooked for severe claims.
Selling insurance must be a profitable business over the long term.
Otherwise nobody would offer insurance.
The same goes for put-selling. If it weren’t for that, we’d just buy puts on everything and top up with futures.
In particular, the sale of money puts benefits from three market phenomena that have been studied intensively.
The equity risk premiums (stocks tend to rise over time), the variance risk premiums (the volatility of stocks tends to be overpriced), and the skew risk premium (the tail risk tends to be overpriced).
This triad makes selling put options a great passive income strategy with a positive expected value.
Many investors say they would never consider selling “high risk” put options.
Even so, ironically, these investors are the same people Sell covered calls as an income strategy.
Message flash! A covered call is simply an ITM put.
Needless to say, it is amusing to watch investors sell puts when they are hidden ITM put sellers themselves.
Conversely, many “gurus” mean that selling puts is easy, risk-free income.
That’s not the case. Selling puts has unlimited loss potential until the stock is delisted.
It is a fact.
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Often times the gurus try to sell a simple income strategy but leave subscribers on the wind when their position moves against them.
You can sell puts all the way down, and that’s not nice.
In order to still generate a substantial income of over a few percent a year, you have to take risks. Selling put options carries this risk.
The amazing thing about options, however, is that the risk can really be tailored to suit an individual’s goals, tolerances, and constraints.
The CBOE has a put-write index that is sold at the money put for 1 month and rebalanced the following month.
The performance since 1997 is slightly below 9% (red line).
Although it lagged the S&P 500 on an absolute basis, it has a slightly higher risk-adjusted Sharpe ratio (0.58 vs. 0.53).
While this may not seem dramatic, I have found that the Sharpe ratio can be increased significantly by slightly moving OTM and while rolling Hedging positions This enables a more consistent delta exposure.
Simply put, the PUT Index can be improved significantly to meet an investor’s desired returns and risk constraints. Let’s see how we can do it!
For the casual investor looking for income, here are a few tips on the best assets, expiration times, and strikes to sell put options.
The first is to focus on selling index options.
Numerous studies show that the variance risk premiums for indices are higher than for individual stocks.
That makes sense.
Most people want to hedge against market risk, not the risk of a particular stock.
IIndex and main ETF Options like SPY are those too most liquid options in the world.
This offers another benefit of reducing transaction costs. When choosing the strikes, focus on the light OTM strikes (around Delta 30) to find a balance where you can get some benefits distort Risk premiums while still exposed to Delta.
Selling more OTM options may seem tempting as the odds of winning are higher, but it also carries increased tail risk due to the amount of options you have to sell.
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In terms of the days to expiration, the choice of options with shorter expiration times increases theta.
However, at the cost of increased gamma and potentially more hedging. Selling puts for 1-3 months is a good balance.
Some investors avoid selling puts in low volatility environments because the premiums are lower.
Even so, lower premiums are offset by lower realized volatility.
There is some research to suggest that selling puts on index options is actually more profitable in less volatile environments.
So as an income strategy, trying not to time the market will pay off in the long run. Unless you have a crystal ball!
While selling index options isn’t sexy, it maximizes all risk premiums and provides the insurance investors are most willing to pay for.
Selective selling of puts on individual stock options can be more profitable, although it requires advanced knowledge and selective timing that most investors and their related gurus lack.
Another problem is that the best long-term stocks also have the lowest premiums.
Sure, Proctor and Gamble is a good, stable company to retire to, but who is buying puts?
This sometimes leads to investors diving into dumpsters and selling puts on stocks that, while inflated in premiums, are terrible businesses.
This in turn leads to underperformance in the long term.
Do you remember when I immediately ignored the red arrow?
It’s back Let’s bring it up now.
A put does not have the same risk as the trade moves.
This is indicated by the purple line. At the beginning, the put we sold had a delta of 30.
This means that 1 put corresponds to 30 SPY shares.
What about the red circle?
Well, at this point our put is 70 delta and we are long the equivalent of 70 SPY shares.
We are now at a higher risk than at the beginning.
Conversely, the opposite is the case with the green circle.
Our put only has 10 deltas.
At this point, it is probably better to roll the position as there is very little credit and commitment in any remaining values.
This is also illustrated by the purple line that shows the current profit and loss.
We notice that the purple line at the other end becomes almost linear like a stick, while at the other end it flattens out to become nothing.
How can we hedge against this increased risk in the red circle?
Here we have the same trade but SPY is now trading at $ 400, we are in trouble!
One of the easiest ways to hedge risk is to simply buy stocks short.
Our delta is now 70, in this example we bought a partial hedge of 40 SPY shares.
Our new payout is the orange line. We see that we have now flattened the line and will lose less as the stock falls further.
Nevertheless, we have factored in a loss in this case.
While it may seem unattractive, holding your bag and hoping for a rebound can be like playing with fire.
Hedging with stocks is just one way to hedge the delta of a position.
We can also close the position and build a new position on our preferred delta.
This option works very well when the option is about to expire as it still needs to be rolled out soon.
Again, this will secure a loss, but it will help reduce tail risk.
Selling put options for income can be a very smart strategy as it leverages various premiums and can produce solid stable returns.
These can be higher than the returns that can be achieved by more conventional methods such as fixed income securities.
Other structured products offer income, but many simply sell the same puts you can sell yourself and include a Manhattan office fee.
Despite this attraction, selling puts isn’t a free lunch.
There is a significant tail risk in the event of market corrections.
By having a plan and hedging during downturns, investors can reduce variance and tail risks in return for smaller losses.
You can both sleep soundly and make selling puts a very attractive passive income strategy.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.