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Options Theory: Short Puts are a Pro’s Long Stock

July 12, 2018

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Pro Members have exclusive access to 31 powerful trading strategies categorized according to the Options Greeks. Bullish, bearish or neutral market conditions, this Playbook will help you trade with greater confidence.

Last update: July 2021

Options carry many perks. Today I want to focus on their capital efficiency and leverage capabilities. To do so, we’re going to compare shorting puts (aka naked puts) to buying stock. Misguided lemmings who tout options as riskier than stock don’t realize that they’re painting with too broad a brush. The reality is options can be safer than stock if used properly.

Options Theory: Short Puts are a Pro's Long Stock

Principle #1: Selling puts is a stock substitute.

Shorting puts is a bullish strategy that carries limited reward. And yet, the continual selling of puts can create potential profits that mimic that of long stock (which provides unlimited reward). The key lies in the constant re-deployment of the strategy.

Multiple studies have been done comparing buying and holding the S&P 500 to selling monthly at-the-money puts. The CBOE even created a strategy benchmark to track a monthly put selling system. It’s known as the CBOE PutWrite Index. A side-by-side comparison of this Index and the S&P 500 reveals just how closely short puts follow long stock.

Which brings us to our next principle.

Principle #2: Selling puts is more capital efficient than buying stock.

The first reason why selling puts is more attractive than buying stock is it ties up less capital. When you get similar upside for less cost, it increases your return on investment. Here’s an example. To purchase 100 shares of SPY at $278 would require $27,800. In contrast, if we sold a single one-month ATM put (the Aug $278 strike), we would receive a credit of $3.42, and the initial cost would only be $5,560, or roughly 20% of the stock cost.

This is a crucial point. Short puts tie up approximately 20% of the capital required for long stock. That means 80% of the money you would have devoted to the stock position is now freed up to trade elsewhere.

Here’s a second critical piece. We are comparing selling one put to buying 100 shares. That is an apples-to-apples comparison because one put obligates you to buy 100 shares of stock.

Principle #3: Selling puts offers the potential for ramping up leverage.

Since the short put requires less capital than long stock, we can tap into the power of leverage. That is, we can amplify our returns by selling multiple puts instead of just one. Instead of selling one put for every 100 shares of exposure we want, what if we sold two or three puts? This would pour lighter fluid on our returns in favorable months in exchange for the ramping up the pain in adverse months. Remember, leverage slices both ways, so I urge you to exercise caution in not going overboard.

Let’s view this from a percentage perspective. If you use 20% of the capital that would have been required for buying stock to instead sell puts, then you’re not leveraged. But, if you used 30%, 40% or 50% of the money then you would be leveraged. In that case it takes a much smaller drop in the stock to lose all your money.

A recent study by TastyTrade showed that anyone who used over 60% of their capital in selling ATM naked puts in SPY would have blown up during the 2008 crisis.

Tapping into leverage is the bee’s knees when markets are rising but the sting when markets crash can kill you if you’re not careful.

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