In honor of the somewhat sideways markets, we have had recently we are going to revisit the trading style that has been working best in this environment and that is cash flow or as some like to call it THETA trading.
We are going to compare the merits of two different theta trades. These two trades are not disimilar but they are not exactly the same either. We are going to compare the naked put vs the bull put spread. These are both great trades with excellent potential for profits but they have some subtle differences and can be used in different circumstances.
Let’s compare three different aspects of these two trades. The most important metrics are ROI, Capital requirements and exit plans. Comparing these three things can give us a good idea of how and when to use each strategy.
Let’s start with the best part and that is the profit potential. The naked put has nice profit potential. The ROI can range from 3% to 15% on margin depending on the stock and the strike price chosen. This is a solid return for the risk involved. The general risk is that you may have the stock “put” to you in which you will need the margin or the capital to purchase the shares. The margin you need to do the trade will be considerably less than the cost of the shares, however, this does not negate the obligation that could come to fruition.
The bull put spread has a much larger ROI because the overall risk is much lower due to the structure of the trade. This structure also affects the credit received. A typical ROI for a bull put can range anywhere from 7% to 20% on margin. This risk in this trade is limited to the spread between the strikes and taking possession of the stock is less of a concern but can still be a part of the trade if need be.
I alluded to the capital requirements in the ROI discussion. With the naked put we have to have the capital in reserve should the stock be put to us and that would be the full cost of the stock minus any margin we may have. This can be a struggle for smaller accounts.
The bull put capital requirements are considerably lower and therefore the ROI is higher. The capital required would only be the width of the spread minus any credit received. This makes this trade very accessible for smaller accounts.
This is the most interesting comparison of these two trades. The naked put really only has a couple of choices. The seller of the naked put can take possession of the stock if the price is below the strike price. The only other choice for the seller of the put is to buy back the obligation should it be necessary.
The bull put has the option of taking possession of the stock if it is desired to do so. This can be accomplished by selling back the long option portion of the spread before expiration and then defaulting to a naked put position. The bull put seller can also let the trade take care of itself, meaning that if the price is below both strikes then the trade will just come off by itself. The bull put spread can be closed at a pre-determined level for a loss as well. The bull put can be changed into other trade types as well.
When we compare these two trades you can see they are both have there good points and both have their own subtleties. There are specific instances where each trade would be well suited to be used. The most interesting thing to compare is the versatility of the bull put spread. The reality is that one cant go wrong using either strategy as long as one is well versed in executing and managing these theta type trades.
Coach “Old Money” Holmes