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Thursday, May 31, 2012

Put Selling as a Replacement For Stocks

The higher that market implied volatility becomes, the more attractive put selling (as a replacement to being long stocks) becomes.

The chart below outlines one such example, this being the put option payoff structure of March 16th, 2013 expiry puts on the ETF SPY. As implied volatility moves higher, the put premium (think of this as the insurance premium you are selling) moves higher (i.e. the payoff structure moves up).

In the example below, the current payoff over the next 10 months of an at the money put is almost 10%, which can be thought of as the "upside" should stocks stay at current levels or move higher, while downside moves in the same 1:1 fashion as owning the underlying SPY ETF (but you are cushioned by that 10%). If you want more cushion in the form of allowance for downside movement, you can sell further out-of-the-money puts (but collect a smaller premium).



A few months back, I outlined that implied volatility was so low that I was replacing some of my long positions with long call options (and short positions with long put options). If volatility moves higher, I will likely be doing the opposite and replacing these long call / put positions with short calls / puts.

Note: the payoff structure in the above chart should be moving down at a crisp 45 degree angle for all of the above put payoffs (the reason they don't is I am being lazy in the number of data points I used to create the chart).