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Puts Over Calls: Comparing Two Popular Option Premium Selling Strategies


Premium selling strategies are a great way to get the wind of time decay at your back, but it's important to understand the risk and reward.

Since the market bottomed early last October it has not only mounted an amazing comeback, but has done so in a way that has created a near-perfect environment for two popular option premium selling strategies: covered calls and cash-covered (meaning, no margin) put sales. The combination of a steady rise in prices and, until recently, a relatively high level of implied volatility, has allowed these strategies to either equal or best the returns of the S&P 500 over the past six months, measured from September 21, 2011, which was about three weeks prior, and 7% above the October low.

The table below compares the CBOE S&P 500 BuyWrite Index (BXM), the CBOE S&P 500 PutWrite Index (PUT), and the S&P 500 Index over various time frames.

Note the BXM and PUT indices have not only outperformed the S&P 500, but have done so with lower risk profile. Over the past five years the beta, or expected price move, for every $1 change in the SPX has been 0.72 for the BXM and just 0.69 for the PUT.

The two positions are essentially the same in terms of their risk/reward profiles. Both have limited upside and both are exposed to a dramatic drop in price. Most importantly, both benefit from a price that is flat to trending slightly higher, and a decline in implied volatility. Over the years it's actually been a bit of a crusade of mine to dispel the myth propagated by mainstream brokers trying to push a commission-heavy "system" that suggests a covered call is a conservative position while selling puts "naked" is extremely risky.

The PUT is based on a strategy of selling a sequence of one-month, at-the-money S&P 500 Index puts and investing cash at one- and three-month Treasury bill rates. The money in the T-bills acts as the cash securing the put sale, so this is a "covered" position.

The BMX is based on buying one SPX contract and selling the one-month option that is the nearest strike above the index price (meaning it will be slightly out-of-the-money).

The above definitions lead to the caveats before a blanket recommendation to engage in a put-selling program.
  • These are both labor- and commission-intensive strategies. The two benchmarks are frictionless in that they do not account for any fees that will be accumulating by rolling positions 12 times a year. Expect a minimum of 1% annual drag on your real rate of return.
  • Volatility levels are an essential part of the relative returns. You can see from the table above that the best relative returns have come over the longer-term time horizons. This can be attributed to the "reversion to the mean" element of volatility levels. Obviously the best time to establish premium selling strategies would be when implied volatility is high, but that of course is a relative term. I think 2012 might offer a nice balance of somewhat elevated implied volatility with a market trending moderately higher.
  • Margining and dividends. Depending on your account type, a covered call can be margined differently than a short put. Even though the PUT is based on a fully "cashed covered" positioned, the different margining would result in different return on investment. Also, it's important to be aware that a covered call in which one owns the underlying security -- this is true even of an ETF like the Spyder Trust (SPY) -- will collect a dividend. While the expectations of a dividend are supposed to be embedded in the option's price, (i.e., puts on dividend-paying stocks are more expensive or have higher premiums than the related call options) in practical terms the assurance of the steady income will often add a few basis points of return.
  • Beta neutralizer. Given that a put sale or a covered call establishes effective buy prices below current levels but locks in effective sale prices, it's no surprise that these strategies come with a beta lower than their benchmark. This means that the drawdowns won't be as great, nor will the profits be as high in a strong bull market
Premium selling strategies are a great way to get the wind of time decay at your back. But it's important to understand your risk and reward, and most importantly, your expectations. Don't expect these strategies to provide alpha; they are ways to benchmark your portfolio and smooth out returns over time. If you don't wish to undertake these premium selling programs there are a variety of mutual funds that are benchmarked too and hope to mimic the PUT and BXM indices.

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