The Difference Between a Buy Write Strategy and Selling Puts
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.
Comments