Edge in Selling Options Part 2: The Put-Write

Edge in Selling Options Part 2: The Put-Write

 

Summary:

  • Selling puts is normally characterized as dangerous; however, from 1986-2015, the strategy had the best risk-reward profile out of multiple strategies tested, as measured by standard deviation divided by total return.
  • Modern managers leverage the put-write to benefit in multiple market scenarios: bullish, flat and even moderately bearish price moves.
  • Short puts have risk down to zero, but the put-write strategy actually had one of the lowest max drawdowns during the period tested.

$100 invested in the CBOE S&P 500 Put-Write Index strategy in 1986 would be worth just about $1,700 today, clocking in at 10.1% annual returns.

A CBOE study recently concluded that despite the perceived risk of shorting puts, the strategy has performed incredibly well, even during the 2008 crash. Specifically, the study tested selling at the money puts on the SPX one month out and investing the secured cash in three month treasury bills. The only other strategy that beat the put-write was the buy-write (BXMD – long the S&P 500 index and each month shorting a 30 delta index call option). At a glance, the BXMD’s 10.7% annualized returns during the same period seems better, but when risk is taken into consideration, it’s not.

Risk Reward

Trades are not risk free. Every investment has risk to it. Standard deviation quantifies said risk. According to Morningstar, “if for example a fund or strategy had a mean annual return of 10% and a standard deviation of 2%, you would expect the return to be between 8% and 12% about 68% of the time, and between 6% and 14% about 95% of the time.” Risk is one side of the equation. On the other side, investors have reward. This could simply be annualized returns. Putting the two together bring more context to the numbers.

The risk reward of any strategy is key. When looking at the put-write strategy, the data is clearly favorable. The study tested a number of options strategies from iron condors to covered combos and buy-writes. Out of all the samples, put-writes had the most favorable risk reward profile—an annualized standard deviation of 10.2% and annualized total return of 10.1% or 1.001 risk-reward.

Other strategies like the BXMD, plain S&P 500 Index, SPX Iron Butterfly Index, S&P GSCI Commodity Index and 30 Year Treasury Bonds had risk-reward profiles of 1.23, 1.54, 1.8, 5.9 and 1.7 respectively. The put-write dramatically outperformed its competition from a risk reward point of view, risking less for every unit of return.

Drawdowns

Another factor to consider when looking at different strategies would be the historical drawdowns. With this in mind, put sales naturally have the worst case scenario of the underlying asset going to zero. The below profit and loss graph displays this.

Article 9 - Edge in Selling Options Part 2 The Put-Write - Pic 2

(Source: Oleg Bondarenko, University of Illinois at Chicago)

While max loss is indeed a factor to consider, the data suggests this is not a likely occurrence, especially on an index with 500 stocks in it. The premium received from selling the aforementioned put actually protected investors from realizing the entire max drawdown. The chart below displays the gross premiums received each calendar year for the put-write index and the recently launched weekly put-write index. Investors will note the gross premiums received from the strategy directly correlate with spikes in implied volatility.

Article 9 - Edge in Selling Options Part 2 The Put-Write - Pic 3

(Source: Oleg Bondarenko, University of Illinois at Chicago)

Tweaking the duration of the short puts resulted in even better drawdowns. The new WPUT index drawdowns are displayed below. This index sells at the money puts on a weekly basis and invests in one-month Treasury bills to cover the liability from the short SPX put option position.

The largest drawdown for the period tested was -32.66% for the PUT. For context, the largest drawdowns for the SPX, BXM, BXMD and Bonds were -50.95%, -35.81%, -42.73%, and -25.96% respectively.

Article 9 - Edge in Selling Options Part 2 The Put-Write - Pic 4

(Source: Oleg Bondarenko, University of Illinois at Chicago)

Following the Big Traders

Weekly puts, when aggregated, brought in more premium than the monthly options each year during the study. However, one of Wall Street’s most famous investors is skipping these short term durations all together and going way out on super long term LEAPS.

Most famously Warren Buffett, one of the richest men in the world, is a fan of put sales. The Oracle of Omaha is a seller of puts in size. According to its latest 10-Q for 2016 Q2, Berkshire Hathaway currently has on $27.9B (notional value) worth of short index puts across a variety of indices around the world. Some over the counter contracts expire out in January 2026—a long term investment for him.

On a mark-to-market basis, Mr. Buffett showed a profit of over $1B in 2015 on this position according to an SEC filing. His investment has been working in his favor due to time decay and bullish price action. In 2014 and 2013, his short puts also collapsed in value, bringing in $108M and $2.8B respectively according to historic annual reports.

Alternative Exposure

For investors that don’t want to put on that kind of risk or want to reduce their margin requirement, there is a solution.

Capping off the downside scenario is an answer to this problem. Investors can purchase an out of the money put option to limit the worst case scenario, thus reducing the capital needed to put on an investment like this, essentially making this a credit spread with a similar net position (delta and theta for example), but not as extreme as it would be otherwise just naked short. There are also a number of funds like the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (PUTW) that actually aims to track the previously mentioned CBOE S&P 500 PutWrite Index (PUT). However, funds like this don’t have the flexibility to take advantage of volatility should it pop, unlike a discretionary opportunistic manager.

Conclusion & Other Applications

In any scenario or strategy, there is clearly an edge in writing put premium. History has shown us that realized volatility is almost always lower than what the market is implying at any point in time – see the chart below of the VIX (S&P 500 Volatility Index) vs. Realized Volatility.

Article 9 - Edge in Selling Options Part 2 The Put-Write - Pic 5

(Oleg Bondarenko, University of Illinois at Chicago)

The put-write, and buy-write for that matter, take advantage of this. Portfolios that leverage this data essentially bring in alpha from fading the implied move and keeping a positive net delta over time. On a related delta note, investors will also find it interesting that the BXMD outperformed the BXM (long S&P 500 Index and short at the money calls) by 1.78% annualized per year due to having a higher correlation with S&P 500 and higher delta exposure. It is also interesting to note that the PUT index had a lower correlation with the S&P 500 (0.84) vs. the BXMD’s 0.95, but only came in 60 bps lower total return wise. Overall the PUT outperformed its competition from a few angles: lower correlation and lower beta, all with the lowest risk-reward profile.

Similar studies have looked into put writing on different products. For example, a research report on the CBOE Russell 2000 Put Write Index (PUTR) was just posted this year. Similar results were also found. For example, “since 2004 the implied volatility for the Russell 2000 averaged 2.88 volatility points higher than its realized volatility” and the PUTR actually had larger returns, less volatility and a higher Sharpe Ratio than the Russell 2000 Index alone. Similar logic can perhaps be also applied to single stocks.

While historical data does not guarantee future results, studies like these give investors confidence when testing out a new strategy on a different product or when evaluating a new manager. Put sales have historically been an alpha generating strategy, as long as realized volatility ends up being lower than implied volatility. Moreover, drawdowns and the risk-reward profile are equally important when evaluating said new strategy or put sale application.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.

 

 

 

 

 

 

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