The dominant consideration that a sold puts strategy hinges on is the consequence of being obligated to purchase the underlying stock after being exercised.

Ideally this writing strategy will be used when the greater probability is that the market is expected to stagnate and undergo a small retracement. In this event, the underlying will soften and enable a lower entry price for the buyer. The sold puts can be closed out in receipt of time decay, or may expire worthless. The premium received will offset the purchase price and so reducing risk, will find the strategy to be even more rewarding.

This risk averse strategy finds its motivation in the desire to own the stock initially, and so the worst result is that the stock is purchased at a higher price, and the writer of the put, loathed as they will be, will need to accept the full premium of the option to offset against the purchase price.

The more flamboyant participant may not intend to purchase the stock, but merely use the writing of put options to affect a bullish view of the market.

This of course will be a splendid result if that is indeed the case however; if this is incorrect it will find the writer at the risk of being put the stock which may be at a considerable premium to the market price prevailing at the time. This will occur after the writer has been exercised, and the fact of the premium received will be of little consolation.

American style options can be exercised at any time. Of course this is a privilege enjoyed by the buyer, the cost of which is defrayed through the pricing model. Rarely does life imitate art in the financial markets however, and so the risk of being put the stock needs to be investigated prior to executing this type of strategy.

The holder of both stock and puts effectively owns synthetic call options, and often the risk of being obliged to purchase the stock by investors who have purchased puts will come from internal forces such as dividend issues, with the most likely time a writer will be exercised being ex-dividend. When a stock holder has received the dividend, and the interest earned on sale proceeds from early exercise is greater than the cost of purchasing the corresponding call, in all probability the put is likely to be exercised.

Taking into account dividend declarations and issues, if the cost of the corresponding call option is less than the interest expense incurred in purchasing the stock, the risk of being exercised is greater than the annualized return for writing the put, and the strategy will be unsound. If forced to purchase the stock, it may well result in a fruitless adventure as the capital loss on a falling stock will far outweigh any premium received in an effort to outperform market performance indicators.

Ideally the benefit of low volatility in the market will support this strategy by way of time decay accruing to the writer who is obligated to purchase stock at an approximate market price. Of course, if uncertainty in the underlying exists, historical volatility can hardly be expected to remain low and the risk increases significantly.

The buywrite strategy will typically be affected to maximize returns using the device of options. Through selling call options, a stock holder is effectively exchanging potential upside gain for the chance of creating a cashflow by accruing premium by writing calls. When executed to equal proportions, the cumulative exposure will result in synthetic sold puts.

In the alternative, naked sold puts can be implemented as a strategy if there is an intention to purchase the underlying at some time in the near future, or if the underlying is envisaged to trade within a range that is slightly higher than the market. In the former case, the premium will offset the eventual purchase price, and a worst case scenario will see the intended purchase of stock be contrived with an early exercise of the sold put options. In the latter case, there is no specific intention to own the stock and upon a downward move, the writer will effectively own the stock in a falling market if exercised. However, the sold puts may produce valuable income from time decay should the market trade within a band for an extended period.

As the option pricing model is so very pedantic, it assumes that possibilities extending from the bell curve in both directions are of equal probability. History reveals however, that while markets have an inherent tendency to rise over time, they fall with far more ferocity and momentum. To address this intriguing quality, the market will attribute more time value to the downside than the upside. This volatility skew will see options strike prices south of the market trade at volatilities that are higher than those above the market. This adapted progression needs some type of linear framework to refer to, and so often a skew will appear to be uniformly applied between strikes.

This being the case, when sold puts are adopted as a strategy as opposed to that of the buywrite, the volatility of out-of-the-money puts will be significantly higher than that of the out-of-the-money call. A higher premium and therefore a higher annualised return is now able to be enjoyed. When one considers the 10-15% p.a. appreciation that stock markets typically rejoice within over the long term, sold puts appear to be the most attractive statistical alternative overall.

However, in choosing sold puts over the buywrite, thought must be given to the dividends that may be forgone through not needing to own the physical stock. If the dividend return is greater than both the interest expense incurred in purchasing the stock, and also the annualised return of the sold puts, the buywrite may be a more prudent investment strategy. 

 Sold puts are high maintenance. They will need margins to be satisfied, and as with all sold options, the cost of possible contingencies will be elevated in favour of the clearing guarantee. The call options sold in the buywrite strategy however, will not need as high margin security, due to an offset being extended in lieu of the physical stock in hand.

The search for alpha necessarily entails performing in excess of the overall market performance index of a similar market. An alpha of 1 is achieved when a portfolio investment outperforms the indicative average market performance by 1%.

Competition in the market place is part of its inherent character; the very precept of the capitalistic philosophy lies in the free pursuit of financial independence within various markets lending themselves to investment and risk. The particular features and idiosyncrasies of a market will dictate the risk it demands and the return that it may provide however, as with any astute investment, it pays to dedicate resources to extensive analysis before committing to risk. In modern markets technology is an indispensible resource for investment analysis and risk assessment.

Options markets do indeed provide opportunities to add value to investments with an aim to outperform the industry benchmarks through supplementary returns. Apart from individual strategies such as the covered call, that have been historically proven to provide an investment with an Alpha in excess of 1, the very anomalies that exist between historical and implied volatility, those that arise as an incident of the pricing model needing to be reasonably adapted to market forces, and those that provide opportunities for complex combinations of derivatives, will all provide success in return if an objective, consistent and mathematical approach is applied.

One limitation of the pricing model is that it assumes that variables remain constant until expiry of the option and reversal of the risk. This of course can rarely be further from the truth, and so on any given day value may be seen in overpriced and underpriced options, which are all too willingly to offer an attractive return to those that learn to recognize them. To characterize these opportunities as ‘value’, a relative comparison needs to be made; it is the epitome of value judgments.

To this end it is suggested that option models be adapted to market conditions as far as possible. In a pragmatic sense, this will mean skewing volatility in order to accommodate a likely change in volatility subsequent to a move in the underlying, to accommodate the presence of specific interest in the market place, or to simply revise ones view of volatility in respect of broader market influences.

In effect, these modifications to the model are reshaping the bell curve and adjusting the gradients of probability, to ensure that the statistical benchmark used in relative comparison will only assume value is present when it is beyond all reasonable doubt; when risk and return are within reasonable proximity. If these opportunities present themselves, it is then that an investment is made and risk is adopted. When value is derived from a stringently adapted pricing model, and is also the motivation for every trade, profitability and return is merely a matter of time.

Higher volatility will mean that higher premiums are demanded by options sellers. Any commodity trader does well to notice that regardless of a pricing model, or theoretical reasoning, an option is only ever worth what the market will bear. A model relies on inputs, and is not responsible for the market differing in its valuation of options.

Of course, the effect of higher volatility on an options price is similar to that of time. Where an increase in days to expiry will lead to higher premium value, there remains a quantified period of time for options to perform, while an increase in volatility does nothing to allow more opportunities; it merely increases the price.

It is for this reason that higher volatility will directly increase the time decay of options. This in turn demands a higher level of performance from options – regardless of its role as a hedge, an outright directional position or one based simply on value. Irrefutable proof of this contention is found in the common experience of a favourable move in the underlying, finding an exasperated trader still suffer a loss due to the higher premium that was paid.

In order to realize a profit or loss, one needs to be realistic about the exit points of the strategy. Particularly with the stock market, it is historically established that markets rise at a slower rate to that when they fall. For this reason, a bull market will routinely (but not exclusively) find a rising market consolidate at each breach of resistance, and volatility will fall. Conversely, when the market is infused with fear, the fall is dramatic and volatility is prone to escalate almost immediately. Quite simply the reason for this is the proposition alluded to earlier; the competing arguments of theory versus reality.

An options model not only bases its calculations on input, but it also assumes that those inputs will remain unchanged till expiry. This will often explain the discrepancy between implied volatility and historical volatility, as the market simply does not envisage the underlying madness (or lack thereof) to remain constant till expiry. A trader may contemplate an exit point, an options model does not.

To protect against these latent risks, every entry trade needs to take into account the most likely scenario at its exit point, and this will not only involve consideration of time decay, but anticipated volatility direction also. It also needs to be borne in mind that the pricing model does indeed have its relevance in moderating the passions of mankind, and that enormous value opportunities are available to a trader cognizant of this fact.

Another contingency that attaches to increased volatility is the cost of holding a position. Clearing houses to this end, are concerned with maintaining security in respect of the risk inherent in open positions. In the execution of this objective they charge a premium margin which will bear some relevance to the most recent market price of options, and therefore implied volatility, but will supplement this with a risk margin reflecting the contingencies of volatility moving up and also down.

Ideally this security will be reflective of the cost incurred in closing the position out, however this is rarely the case. Usually, open positions in their entirety will be considered and a series of offsets will be affected however, per option add-ons are not uncommon. Effectively a guarantor, a clearer will prefer to err on the side of caution and require a risk premium on the reversal cost of the position to compensate for the anomalies between the model and the market that was referred to above. Further still, clearers will also possess an element of subjective concern, which in climates of high volatility, will only increase the cost of trading, a contingency that needs some measure of forethought  on the part of the trader.

Of course the Greek values used in the course of option pricing can all be statistically graphed; however none is more useful in graphical format than the gamma of an option.

The gamma is the rate of change of an options delta, and will increase as the market approaches the strike price, and decrease as it moves away from it.

Given that the delta is the rate of change of an options price to a corresponding increment in the underlying, an options gamma is then found to be ‘the rate of change, of the rate of change’ of the options price to a corresponding increment in the underlying. As much an exercise in the ludicrous as this may appear, it is absolutely accurate in its assertion.

At-the-money options have a delta of 50%, and it is just such options that have the greatest rate of change of delta; the greatest gamma.  Other options have a delta that changes also, but it is the at-the-money option that does so to the greatest extent.

Particularly when the competing interests of time decay and underlying market direction are being considered, it is often the case that one needs more or less as the case may be, of the rate of change of the options price to the incremental move in the underlying.

This is only possible with acquiring more gamma and directing these options and their characteristics into the portfolio. It is with the use of at-the-money options that this is most efficiently achieved, however it is also possible to choose alternative strike prices, although significant volume changes will need to be affected in order to meet the same ends.

For example, the gamma of an out-of-the-money option may be 0.0025.  This means that the delta changes by 0.0025% for an increment in the underlying. An option with a delta of 17%, for a one point increment would increase its delta to 17.25% or 0.1725. With a four point move it will experience a change of 1% in delta. By comparison, an at-the-money option will have a delta of 50% and a larger gamma than the previous example say, 0.0045. For a one point move in the underlying, the options delta will change from 50% to 50.45% or 0.5045. With a four point move, this options delta will then experience a 1.8 % change in delta.

If resort to the out-of-the-money option is had, it will need a little less than double the amount of at-the-money options to achieve the same exposure. When portfolios need cover with expediency, it is with judicious use of at-the-money-options that the most effective strategy is achieved.

You have a great setup, double top and MACD divergence in a higher timeframe, you see the entry in the lower timeframe, the MACD divergence. You have a goal for where the price should be going and you've bought your put appropriately. Of course this may be one of many option positions you have going. Monitoring these positions manually for an exit is just not feasible for many traders. Here's where using AIQ TradingExpert Pro RTalerts comes in.

Here's an example of a setup from yesterday.

Macys [M] in the first chart, shows a double top forming on the daily chart with an MACD downside divergence. The Monthly and weekly charts do not show the price and MACD diverging.
 





In this context a short term trade using lower timeframes (60 min) might be considered. The 60 min chart from 5/13/2010 shows MACD turning down.



So say you bought the May 24 puts on 5/13/2010. You're about a week from expiration. What's a good exit? Having entered on the downturn in the 60 min MACD, we could consider exiting when the 60 min MACD flattens out or turns back up. You could monitor this visually, maybe looking at even lower timeframes and waiting for the MACD to begin the process of flattening out. Better yet is to setup an alert. If you use AIQ TradingExpert Pro, RTalerts is the place to do this.



From the AIQ Main Menu, launch Alerts. use Tickers, Add, from the menu in Rtalerts to add the underlying tickers. Set the timeframe button to 60 min. Now we need to add the alert. We are looking for the 60 min MACD line to flatten or turn up. To do this we go to File, Alert Properties, Edit alerts. In the Alert code screen, scroll down to an empty line at the bottom, and copy and paste in this alert 

!MACD SELL MY PUTS
Sellmyputs if [MACD]>val([MACD],1) or [MACD]=val([MACD],1).

For call positions I'm looking for the opposite exit, MACD to flatten or turn down, copy and paste in this alert

!MACD SELL MY CALLS
Sellmycalls if [MACD]<val([MACD],1) or [MACD]=val([MACD],1).

Click OK. You are back in the Alert Properties screen. Scroll down and find the alert in the list. Right click on the alert and select Alert Enabled. You can also add a sound from the right click. Make sure there is a check mark in the Alerts Enabled box, and click OK.
 


The alert is now set.

Important Note: The alert will fire on any ticker in your list and is dependent and fires only on the timeframe you are viewing.