Trading Naked: How to Cover Your Assets

I recently had a conversation with a good friend of mine. Our friendship blossomed when he talked about puts one day in our Applied Investments class. My head whipped around to locate the person that was finally speaking my language, and once we did the options trader secret handshake, we became fast friends.

One of our more recent conversations surrounded the economics of options – He said that basically, if you’re on the sell side of a naked option, your margin requirement (collateral) is going to be pretty high.

But I disagree.

My friend said, and I quote (with his permission), “basically, options are only economical on the buy side for retail investors”.

This made me kind of sad.

I have this blog so I can help make option knowledge available to retail investors. And there’s so much knowledge out there that sometimes it can get overwhelming. Like I said on my soapbox on the last blog, it takes some time, but the investment (in yourself) is so worth it.

And trading options can be far more profitable than simply being long stock (especially on the sell-side).

So let’s compare selling a put vs. simply buying stock. I’ll also briefly talk about buying a call to address what my buddy was saying earlier about the buyside.

If I sold a 272 30 delta OTM naked put with August 17 expiration against the SPY, with the stock price at $275.26, I would be facing a pretty significant buying power requirement of about $27,000. I would receive a credit of $119 for selling this put. (as of 6/21).

short put

Sounds kind of expensive…

HOWEVER.

I do not have to cover that entire $27k in my account. I only have to cover my margin requirement, which is 30% of that Buying Power Reduction (BPR). So as long as I have about $8,100 in my account, I can make the trade.

[Side note: Okay, so I began writing this blog on Thursday (6/21) of last week. (yes, sometimes it takes a long time to write these things). Since then (6/28), the market has been pretty wild. The SPY is now down to $270 and volatility is up (woo-hoo!)

HOWEVER, I wouldn’t sell the 272 at this price point because it is ITM (in-the-money), but man. It’s just so COOL. I would have been close to getting my breakeven breached, but still would be in the clear. If I had been simply long the SPY at $275, I would be in trouble (about $500 in the hole).

If I were to do the trade in the current environment (and was still bullish), I would execute at the 264 30 delta OTM put collecting a $279 credit. The only reason the credit is higher now is because volatility has gone up in recent days, allowing me to collect some more premium. That’s why when everyone else laments volatility, option sellers cheer!]

An option is a replication of 100 shares of stock. So selling a naked put, like I just did, is one way to replicate buying 100 shares of stock.

To compare, if I bought 100 shares of the SPY, I would be facing a BPR of $27,526 (and I wouldn’t receive any credit AND I would have to cover the ENTIRE collateral). So I have a much HIGHER draw out with simply buying shares.

Selling a Put Buying 100 Shares
Margin Requirement 30% of BPR Entire BPR

So not only do I put up less collateral when I trade the option, I also have a higher return on capital. I put up less capital, and that enables me to actually put on some more trades, and thus, make some more money.

Also, the risk is not skewed towards options like people think that it is.

[Edit: Tasty Trade actually did a segment about this on 6/27, which was brought to my attention after I finished this blog. They backtested an ATM put, managed at 50%, and cross compared that to going long on 100 shares of stock. Little bit different than my OTM put, but I’m just trading at a higher POP, and the ATM has a higher ROC. It boils down to risk preference.

As always, they had a really neat graphs in their presentation, which I have inserted below. Basically, you get the same returns from a short put that you do long stock. BUT, short puts have a MUCH higher return on capital. So every dollar that we invest in a short put makes $2.65, whereas for stocks, that same dollar only makes $1.60. EVEN in 2008, when the markets were terrible.]

1TTA

2TTA

Both Images via Tasty Trade 

So with that great interjection from Tasty Trade and their research, it’s pretty clear that the risk profiles for buying a stock and selling a put are basically… the exact same.

So what I’m saying is… you can pay less for stock… for the same return… and a higher probability of success… by selling a put.

WHAT A DEAL.

Selling a Put Buying 100 Shares
Margin Requirement 30% of BPR Entire BPR
Return on Capital 265%* 160%*
*data from tasty trade

Buying stock and buying a naked put basically achieve the same thing. They are both bullish trades. However, when I trade the put, however, I get to collect credit that enables me to still profit if the price goes up, stays the same, or goes down a little bit (but not past the 270.81 breakeven).

If I had traded the stock on 6/21 and if it dipped below 275 (which it has) I would be in the red. Selling my put has enabled me to stay in the GREEN, EVEN THOUGH THE STOCK HAS MOVED DOWN.

Making money when the market goes down is the BEST feeling!

I am going to talk BRIEFLY about buying a call, just to address my friend’s point about the buy-side. If I bought the 275 ATM 50 delta call with August 17 expiration on 6/21 against the SPY, I would be facing a max loss of the debit that I paid for the call, in this case, about $254.

Update on this trade 6/28: I would be very much in the red on this trade and I would be very sad.

Not only do I have to pay for this trade, but I also have a HUGE breakeven that I have to cover. The stock price has to go all the way up to $277.54 before I even make a penny!

3TTA

That’s really not a good deal.

And the probability of it happening is pretty low.

The probability of all three strategies differ – the short put, the stock, and the long call (assuming a log-normal distribution – also noting that using deltas for POP will tend to cause overstatement, as the model is always increasing) is quite different.

For my short put, I can calculate my breakeven point as the strike price (272) subtracted by the credit received ($119/100), which would be $270.81.

My probability of profit would calculate to be (100 – Probability of Breakeven Point Being ITM[aka delta]) which in this case, is equal to 0.26 (rounding up to the 271 strike). So I would take 1-0.26 to calculate my probability of profit, which would equate to 74%.

That’s pretty high.

For my call, I can do calculate my breakeven point as the (strike + debit paid). So in this case, it would be 275 + 2.54, equating to 277.54 (which is really high). The probability of profit would be about 38% (calculated from looking at the deltas of the 277 strike).

So I can short a put, and make money if the stock remains above $270 (70% chance of this happening) or I can buy a call, and wait for the stock to grind past $277 (38% chance of this happening). Or I can buy some stock, where I hope that it just goes up.

For the stock, the breakeven is just the price I bought it at. So if I bought 100 shares when the stock was trading for 275, I would only make money if the stock went to $275.01. $274.99 would be a no-go. That gives me a 50% chance of profit. It either goes up, or it goes down.

Selling a Put Buying 100 Shares
Margin Requirement 30% of BPR Entire BPR
Return on Capital 265%* 160%*
Probability of Profit  70% 50%
Breakeven Strike Price – Premium Collected Strike Price

So when we look at the comparison chart summarized above, the answer is pretty clear. I try not to come off as too opinionated on this sort of stuff but in this case, all the answers point to shorting a put.

You pay less for the same thing, while putting up less collateral, which enables you to have a higher return on the money that you have invested. You profit if the stock remains the same, moves up, or moves down a little bit.

With stock, you pay a lot for a 50% chance of being right.

The only time we would really want to buy the stock is when the stock price blows up into the stratosphere, like Netflix has done. But no one really can predict when unicorns like that will emerge (if you can, please email me). Otherwise, collecting that higher return on capital, higher probability of profit, and the ability to make money if the stock price goes DOWN, that we see in the short put is unbeatable.

It doesn’t have to be expensive.

It doesn’t have to be crazy risky.

Manage your risk. Manage your TRADE. Do what is best for your account. Don’t do crazy things. Use math to make money. Pay attention to deltas. Pay attention to breakevens.

As always, this is not investment advice, just investment knowledge. Thanks for reading.

(Side note: I use TD Ameritrade. Different brokers may have different margin requirements for options.)

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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