Short naked put vs. short put vertical spread, open for discussion.

Posted by: Admin: "The Vol_Trader"  //  Category: Trade strategy

Today, I’m going to try a new format. 

I received an email from a reader that I wrote a relatively quick response to. 

What I am going to do/try is to post his question here and my response and open the comments up to discussion.  Please participate….  – Lawrence

PS: I’ll post a continuation to the OTEX (losing) earnings trade later too…

Note: the reader’s name has been changed for privacy, it was not Elwood Blues writing…

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08/23/2010 Elwood Blues sent in via email:

Hi there,

I am trading mainly stock options and usually short sell out-of-the-money puts. The strategy is doing fine, but I am currently thinking about my risk management:

- Usually I follow the double out rule (i. e. as soon as an option reaches the double premium I got for it, I close it to limit my losses). But this rule kills you in a volatility spike – you are stopped out, even if the stock is still far out of the money, sometimes even moving in the correct direction.

- A friend of mine advised me to look only at the intrinsic value. This of course protects me from being caught in volatility spikes, but the losses are much higher.

Do you have any good idea?

Best regards,

Elwood

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8/23/2010 Lawrence “VolTrader” wrote via email:

Hi Elwood, to answer your question completely would require a pretty long options education, rather than just an answer but I will do my best to give you a simple explanation…

You are right when the underlying moves against you the vol spike will increase losses.  This works in your favor as the market goes up, vol goes down and your short put benefits, a double edged sword.

A simple fix to this is to sell a put spread instead of a naked put.  This means sell your OTM put and buy a further OTM put as protection.  This limits your losses, reduces your margin requirement and protects against vol spikes.  As your short put gains in value due to the underlying going down (delta effect) and gains in value due to vol increase (vega effect) your long further OTM put also gains in value due to delta and vega…  Also, because these are limited risk (not unlimited like short naked put) you can hold them longer and see if your underlying moves back in the favorable direction and allow time decay (theta effect) to work in your favor as both options lose value over time, the closer to the money short put faster.

Elwood, can I post this conversation to my blog and open it up to discussion through comments?  (I’ll just put a fake name for you)

Lawrence

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08/23/2010 Elwood Blues sent in via email:

Thanks a lot for your quick reply! I thought about this strategy as well – the minus is only that it will also limit my possible profits…

Sure you can put it to the blog!

Regards,

Elwood

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4 Responses to “Short naked put vs. short put vertical spread, open for discussion.”

  1. steven kemp Says:

    I sell naked puts only on stocks I want to add to my portfolio. Specifically, if a stock is above what say Morningstar considers fair value, I’ll sell a naked put if the premium is enough to bring the final sale below fair value. If I get “put” the stock, I get the stock at a fair price. If not, I retain the premium and I’ll sell another one. I’ve also used bull put spreads to partially finance the purchase of calls. Used ratio put spreads as well on stocks that may more over-valued, but I still want to own, preferably for credit.

  2. Admin: "The Vol_Trader" Says:

    Hi Steven, thanks for the comment.

    I also sell puts when I want to buy stock. Very often I’ll buy the stock and sell a put at the same time. I hate when I sell a put and the stock rallies hard. I know my personality, this pisses me off. So, by buying the stock and selling the put I participate in the rally.

    Selling the bull put spread for a credit to finance the long call is very similar to a long combo (-p, +c, different strikes) or synthetic long stock (-p, +c, same strikes) without the unlimited downside risk. This kind of trade is very long vega. As the market goes up your puts become worthless and you’re just long calls which are long vega. Vega however, hedges your downside. As your underlying moves down your long calls become hurt by delta but helped by the increasing vega until they are worthless and then you’re just short a losing bull put vertical with limited risk.

    And finally, I really like your short put ratio spread idea. You’re right if the stock moves up and keep the credit for the spread and you’re right if the stock moves down into the short strike price keeping a huge gain and you can buy the stock cheaper than if you just sold the put alone if you get assigned!

  3. Marylander Says:

    Good insight. I came to your blog from Surly Trader, and glad i did. I am option newbie so i’m just getting familiar with the lingo and options trading.

    Let’s say i buy the put spread (i guess the opposite of “sell your OTM put and buy a further OTM put”) i mean doesn’t it make sense to sell the spread when you are bullish on the underlying? Surly says put ratio spread generates credit so why not pick up extra $$ by selling more further OTM put? I tried to make that trade (paper money) on SPY options by buying 50 Nov 100 puts and selling 75 Nov 95 puts. But honestly i have no idea what is driving my P/L right now.

  4. L+2500bps Says:

    Marylander, your long put ratio trade – is it a net credit or debit?

    Back to the original question, I only short naked puts or put spreads shortly after sharp negative events. IV is pushed up so much relative to mean reverting average that the risk-reward is acceptable. Otherwise, shorting puts & put spreads month-in, month-out will get you found out eventually. And even if you wanted to own the stock, there will be ones that will keep cratering and shatter your pnl.

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