EFT Options – Selling Puts
Certainly taken with a view to either purchasing the underlying in the foreseeable future, or conversely with a view to the underlying trading in a range tending slightly toward the upside, the practice of selling puts is not as outrageous as it may at first appear. If indeed the underlying is going to be acquired, if the market falls the options may be exercised and therefore contrive what was envisaged in the first place – ownership of the underlying. However in this situation the price of ownership has reduced somewhat, and the premium received from the sold options will also offset the purchasing expense.
On the upside, the premium will again be retained and serve to compensate against the now higher price to be paid. Alternatively, the underlying need not be purchased at all; the premium may simply be retained as profit. When the market is expected to trade within a range for some time, the practice of selling puts will prove to be lucrative should this indeed be the case. Time value will erode to the benefit of the seller. Time value reflecting volatility will be a component in the option price, and so be captured once the transaction is affected. Apart from the fact that markets rise slowly, the fact that they indeed appear to display disturbing momentum when they tumble, is in this scenario used to the advantage of the seller.
Fully aware of the tendency to higher volatility on the downside, equity option markets will invariably adopt a skew that will extend across all strike prices reaching higher volatility as the strike price is lower. This necessarily means that the seller of at-the-money or out-of-the-money puts will receive statistically higher premiums than a normal bell curve of probability will produce. If prices are achieved that are even higher than what the skewed model reveals, then an even greater mathematical advantage accrues in favor of the seller. Considering the historical appreciation that equity markets enjoy by virtue of inflation, enormous theoretical edge is found in the selling of puts.
While synthetic puts are able to be replicated with covered calls at a par ratio, the volatility reflected in the premium received for sold calls is far less attractive, and so a higher annualized return is possible through selling puts. One consideration that may erode this advantage to some extent is the possibility of dividends accruing through underlying ownership of stock in a buy write strategy. Balanced against the interest expense of purchasing stock, dividends may at times make the covered call the more advantageous strategy. Additional thought ought to be given to the funding costs of sold puts against that of the covered call. Particularly with the increase in policy and regulation by clearers, the cost of holding uncovered positions will increase exponentially.
Categories: ETF options puts
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