We’ve seen massive swings in the value of put options over the past few months. There are lessons to be learned here.

Selling a put option is otherwise known as a naked put. When selling out-of-the-money puts (those with a strike below the current stock price), it’s a bet that the stock won’t fall by a certain amount. In other words, you’re betting on an event not happening. If you’re right, you get to keep whatever premium you received at trade entry. If you’re wrong, then you have to give back the original premium plus potentially a lot of your own money. That’s the risk.

When selling puts, you’re essentially an insurance company issuing a policy to someone who wants protection. For example, suppose an investor owns 100 shares of SPY, and it’s trading for $400. To reduce the downside risk, they buy a January $370 put for $4 per share ($400 per contract). The contract locks in the right to sell their shares at $370. For the put to be worth anything at expiration, SPY would need to fall below $370. In other words, buying the $370 put is a bet that SPY will fall below $370.

Now, suppose you’re the one who sold the put to them. You’re obligated to buy their 100 shares at $370. It’s an event that carries a lot of risk if the stock ends up imploding. Selling the $370 put is a bet that SPY will not fall below $370.

This is similar to a homeowner buying fire insurance. The only way the insurance pays out is if a fire occurs. The insurance company issuing the policy is betting the fire won’t occur, just as a put seller is betting a selloff of a certain magnitude won’t occur.

Premium and Perceived Risk

How much a homeowner is willing to pay for fire insurance (and simultaneously how much the insurance company will demand as payment) is a function of the likelihood that a fire occurs. If you live in a modern home made of steel and glass in the middle of a big city with nary a tree or shrub, it’s likely that fire insurance is dirt cheap.

Alternatively, if you live in a log cabin in the middle of a hot, dry California forest with a history of burning down once a decade, then you’re going to pay a pretty penny for fire insurance. And that’s if you can even find an insurance company willing to take you on.

The perceived risk of loss ultimately drives the cost of insurance.

The same dynamic plays out in the options market. Selling puts on crazy, volatile stocks rewards you with more money because you’re taking on more risk. Selling puts on boring, stable stocks rewards you with less money because you’re taking on less risk.

Even if you’re selling puts on the same stock or ETF every month, the premium available will fluctuate based on investors’ current perception of risk. When pessimism reigns and the future looks grim, you will be able to sell puts for a handsome amount. When optimism reigns and the future looks bright, your payday for selling puts will shrink dramatically.

This should be intuitive and ties closely to the price performance of the S&P 500. As the S&P 500 falls, perceived risks rise. If you sell puts when SPY is steeped in a downtrend and just sold off for two weeks straight, then you’re going to get PAID HANDSOMELY. As you should! You stepped into the middle of a forest fire and started selling fire insurance!

If you wait until the SPY is in an uptrend and has rallied for two straight weeks, and then you sell puts, well, you won’t get paid much. But you don’t deserve a large payday because you aren’t taking as much risk! You’re the company selling insurance to the modern homeowner with a dwelling of steel and glass downtown. Why should you get paid a lot?

What of the VIX?

Since perceived risk moves inverse to the price of the S&P 500, you can probably just use a SPY chart to infer how much you will get paid for selling puts.

Or you could use the VIX.

The VIX tracks options premiums directly and reflects how much people pay for protection. Consider it a “perceived risk” indicator. When the VIX is high, put premiums are extremely juicy. When the VIX is low, put premiums are tiny.

Notice what’s happened over the past two months as the S&P 500 has entered an uptrend? The VIX has gotten clobbered. Perceived risks have fallen. The fire that had stocks ablaze in October has all but gone out. You can certainly still sell puts, but you’re not getting paid nearly as well as you used to.

Here, again, is the key point. Indeed, it’s why I wanted to focus on perceived risk and put premiums today.

If you refused to sell puts in October because the market was unhealthy and risk was too high and you wanted to see things improve first – then you got what you asked for. But confirmation isn’t free. The cost of your waiting is that your payday is now far smaller.

If instead, you sold puts in October when the SPY was seemingly going to zero and uncertainty was sky-high, then you scored a far bigger reward.

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