From Our November 2015 E-mail Archives: Our Head Trader, Robb, sent an e-mail to one of Maverick's traders regarding his short/naked put position and suggested a better alternative to trading naked.*
In this case, there was only an e-mail from Robb to the trader and no original e-mail message from the trader. At Maverick Trading, we constantly review our traders' accounts to ensure proper risk management. Robb was doing this when he came across a trader with short put options in his account. Robb sent the e-mail below, which we believe is important for all of our traders to see.
Whenever I see someone selling/shorting options, I want to make sure that they understand that the math shows a Bull Put Spread (or Bear Call Spread) is superior to a Short Put as far as % return and absolute risk.
To illustrate this, let’s use your five (5) contracts short position in KMI December 25 puts:
Short Put Position
- Position: Short 5 x KMI - December 18th – 25 puts
- Entry Price: 0.90
- Profit Potential: $450 (less commissions)
- Absolute Risk: $12,050 (While this is the absolute risk if the stock goes to $0, we understand that is very unlikely; however, this is the absolute risk and you will occasionally have trades that lose 50%+)
- 2 SD Risk: $1,905 (A 2 standard deviation move down was calculated at 20.29 at the time of your trade entry)
- Return on 2 SD Risk: 23.6%
- Margin Required: $1,685
- Return on Investment (margin): 26.7%
Now, let’s compare the above to a 5 contract position of a KMI December 18th 22/25 Bull Put Spread.
Bull Put Spread
- Position: 5 x KMI - December 18th - 22/25 Put Spreads
- Short 5 x KMI - December 18th - 25 puts: 0.90
- Long 5 x KMI - December 18th - 22 puts: 0.20
- Total Credit: 0.70
- Profit Potential: $350 (less commissions)
- Absolute Risk: $1,150 (While this is the absolute risk if the stock goes to $0, we understand that is very unlikely; however, this is the absolute risk and you will occasionally have trades that lose 50%+)
- 2 SD Risk: $1,150 (A 2 standard deviation move down was calculated at 20.29 at the time of your trade entry)
- Return on 2 SD Risk: 30.4%
- Margin Required: $1,150
- Return on Investment (margin): 30.4%
Comparing the two side by side, you can see the Bull Put Spread delivers both a superior Return on Risk and Return on Investment. When you look at Absolute Risk and even a 2 standard deviation move, the Bull Put Spread is superior.
At Maverick Trading, we always discuss capital allocation. In the two scenarios above, the Bull Put Spread will tie up less of your trading capital. This would become even more evident if this was a higher-priced stock. If you did the same analysis above on a $100 stock, then the margin on a Short Put would be just below $10,000, while the Bull Put Spread would still be $1,150. When compared side by side, the Bull Put Spread has much better “math” (and, thus, makes more sense) than the Short Put strategy.
With that said, there is a price point where the Short Put and Bull Put Spread are fairly comparable. We have found this to be around a $10-15 price on the underlying stock. Even then, though, the Short Put will always carry more Absolute Risk, which still makes the Bear Put Spread superior.
Hopefully, I have laid out everything in logical detail. While I don’t hate the Short Put strategy, it is so much better to just buy a far out-of-the-money (OTM) spread. I tell traders that if you want to sell a $100 put, then also buy a far OTM $90 put for 0.10. It changes the entire dynamic of the trade and makes it safer because of the Absolute Risk of the Short Put strategy. I suggest that you take a look at your trading plan and see if this makes sense for you.
* NOTE: Some original wording has been modified for legibility.