Options Trading News

December 7, 2011  Wed 8:33 AM CT

I think that most option traders, especially new ones, would assume that a long-call strategy would outperform a long position in the underlying stock and that short puts would be a losing strategy, or at least a highly volatile one. But a recent report challenges these notions.

Buying calls is limited-risk strategy with potentially unlimited profits, at least on paper. You get exposure to the upside with limited downside, but you pay a premium for that asymmetrical payoff.

On the other hand, selling puts is considered highly risky, as you may be forced to buy stock at well above the actual market price on a big decline. It is a strategy that has led to the demise of some very big names.

But a recent report from GMO, a firm that manages $93 billion in assets, did some testing on such strategies. While the main point was to look at the relative performance of low-beta versus high-beta stocks, it did so with a comparison of buying calls and selling puts.

The call-buying strategies significantly underperform owning the market. It is clear that the shorter the term of the options, the more the time decay affects the positions. That is why the one-month calls do the worst.

This makes more sense when we think about the equivalent position. A long call is essentially the same as long stock plus long puts. In this context it is easy to understand the drag on performance of put "insurance" on the portfolio. (It is also an argument for more complex hedging strategies, though some use it as an argument against hedging at all.)

So you are essentially paying a price for an asymmetrical payoff--and the data suggests that you are paying too much.

Conversely, the put-selling strategy significantly outperforms the market. And it does so with a huge reduction in volatility--roughly 30 percent--with a much smaller maximum draw-down. Wait, you say, what about those guys who went out of business selling puts?

Well, a 10 percent average annual return does not justify "2 and 20" hedge-fund fees (which would leave you with a roughly 6 percent return, depending on the math). So institutional traders who take on these positions usually do so with leverage--and sometimes a lot of it.  

The basic idea behind put selling is that you get paid a premium to take on the downside risk of the market. It is known as a "concave" strategy because it has limited upside and increasing exposure to the downside with essentially all the risk of the market (minus the premium).

The lower volatility stems partly from not partaking in the upside. And the smaller downside is related to the higher premiums that come during market stress. The near-term options have greater time decay and pay the most because they have the least premium cushion and therefore the most risk. (See our Education section)

So put selling can have a place in a diversified option portfolio. You certainly have to be careful with it, but you can get paid for taking on risks that others don't want. Just ask Warren Buffett, who is arguably the single biggest put seller in the world.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Nov. 30.)
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The covered call and unhedged risk

I have written a few things on the Covered Call Strategy over the last two weeks. Please understand that those two previous articles plus this one do not constitute a proper, fully in-depth lesson on the Covered Call Strategy like we have in our classes at Option Monster Education. I have picked out a few topics that I believe were worth noting and today I am going to add the final one.

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