Short-term or Long-term Option Selling – Understanding Risk and Return – Investor Question

Understanding Risk and ReturnOn my Yahoo options forum recently a discussion focused on an investor wondering why those who sell put strikes would choose what looks like a riskier put strike that expires in two weeks versus selecting a further out of the money put strike which pays more and has over two months to expiry. It would appear that the less riskier trade is taking the two month out trade. The answer though comes down to understanding risk to capital versus the reward to a portfolio. Let’s look at his question and then look at a possible solution.

Investor Question:

I am fairly new to naked put writing, but what I’ve noticed is that one can get a lower strike price, better downside protection with similar or higher premiums by going out 2-4 or 5 months. Which would tend to lead toward not being assigned (stock) and more money in the pocket.

Why do I see so many on the group (my yahoo forum) who are writing $1-2 below current price with less than 10% downside protection and then have to deal with assignment or rolling (their in the money naked puts) down and out?

For example:

CBI stock (Chicago Bridge & Iron Company) current price $76.25

(naked puts being considered)
Feb22 (options expiry)  $75 (put strike – can be sold for ) $1.15
Apr19  (options expiry) $70 (put strike – can be sold for) $1.40

I’d appreciate the feedback. Thanks.

Answer On CBI Stock:

Often it appears to investors that the better trade would be the April 19 expiry which pays more, is at a lower strike and won’t expire until April 19. But actually if held until April 19, this trade pays just 2% for 10 weeks. This means a return of .20% a week. If this return was made throughout the year it works out to 10.4% for the year. While still certainly not a bad return at 10.4%, the Feb 22 naked put at the $75 strike returns 1.53% for two weeks of risk or 0.76% a week. If this trade could be repeated throughout the year the annual return is 39.78%.

Which is the better and safer trade to enter

It comes down to understanding risk to the capital being used for the investment, versus the return to that capital in use….the remainder of this strategy article is for FullyInformed Members.

 This strategy discussion article is 2500 words in length and will require 6 pages if printed. It is for FullyInformed Members.

Short-term or Long-term Option Selling – Understanding Risk and Return






 

Disclaimer: There are risks involved in all investment strategies and investors can and do lose capital. You always trade at your own risk. The author assumes no liability for your investment decisions. Read the full disclaimer.

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