Steven Smith Blog
Sell Puts and Relax
By Steven Smith
11/1/2007 2:43 PM EDT
Probably one of the worst option positions to be holding coming into today would be short puts. As this morning's lower opening quickly turned into a midday rout, anyone that premium probably has a sinking feeling in the pit of their stomach. Suddenly the strategy of selling puts as a reasonable way to participate in a steadily rising market and earn incremental income along the way by collecting option does not seem so palatable.
At least that's what that's what I thought, which was one of the reasons I was initially skeptical when the Chicago Board of Options Exchange launched Put/Write Index (PUT) back in June. As a quick reminder, the Put/Write is basically a sister product to the CBOE's incredible successful BuyWrite index (BXM), which has become the benchmark and has helped fuel the boom in broad-market covered-call funds. Remember, the risk/reward profile of a covered call is essentially the same as selling a naked put.
What, Me Worry?
The main difference will be the Put/Write is secured against cash, while the BuyWrite uses the ownership of the underlying stock or security as collateral. The PUT strategy is designed to sell a sequence of one-month at-the-money S&P 500 index puts and invest cash in one- and three-month Treasury Bill rates. For details on the contract specifications, a white paper and historical returns, check out this page on the CBOE Web site.
The nut is that backtested data covering the past 20 years show the PUT index had an annualized return of 12.6%, compared to BXM's 11.8% annualized return and the S&P 500's 12.1% return over the same time period. The PUT also had a lower beta -- was less volatile -- than either the BuyWrite or underlying index.
Do Not Criticize What You Don't Understand
My wariness of this product was a laid out in this article from late July as the subprime meltdown started to kick in and send the market into a free fall. This prompted me to get in touch with Ansbacher Investment Management of New York, the only firm CBOE licensed to create an option-based product based on the PUT Index.
Jason Ungar, the director of investment at Ansbacher, was gracious enough to meet with me and smart enough to explain why the Put/Write is not any more risky than any number of income-generation strategies and also the mechanics of how it tends to outperform not only covered calls but also other premium selling strategies.
"The key is lies in the skew in the prices for S&P 500 index options," says Ungar. He explains that puts, because of the demand for downside protection, coupled with the popularity of selling calls to create covered or buy-write positions, makes the price of puts slightly higher than the comparable call option. This includes the dividend that I factored into option prices.
While the BuyWrite and Put/Write both theoretically sell at-the-money options, the fact is the underlying index is rarely right at a strike price, meaning both essentially sell options that are slightly to one strike out of the money. This further pushes the skew in favor of selling puts as out-of-the-money puts often garner a higher price, in the form of a higher implied volatility, than calls.
Let Me Take You Higher
So the fact is that as the market has entered a higher volatility environment in which the VIX is running in the 20% level, compared to the low 10%-13% level that dominated 2005 and 2006, should theoretical result in higher returns as the S&P 500 rises or a smaller loss as the index declines.
Last week, I got back in touch with Ungar to see how the index fared through the summer turmoil. The numbers bear out that this product is not only holding its own -- it has been outperforming the market even as the turmoil hit the fan.
In August, the Put/Write returned 2.05% compared to the S&P 500 gaining 1.5%.
In September, the PUT gained 1.66% as the S&P roared to a 3.73% gain.
In October the PUT gained 2.79% compared to S&P 500's 1.59% gain.
It is interesting to note that as Ungar says, "We got a little lucky on Oct. 19" due to the mechanics of how both the BXM and PUT are structured.
If you recall, that was the expiration day in which the S&P 500 ended down nearly 2% on the day. But the because of the quirky settlement process of S&P Index options, which cease trading Thursday but are based on a SET or Friday's opening prices and can take several hours to compute, the roll of selling the next month's option does not occur until around noon on Friday. That meant the PUT did not initiate its new sales until the S&P was down about 1% on the day, allowing it to outperform the Index by about 0.22% on the day.
Unger sums up the strategy saying, "Too many people continue to be surprised that selling fully collateralized puts is a better and safer and lower-volatility way to gain equity exposure than simple 'indexing.'" My next question to him was, when will we get an exchange-listed product in which we can invest and participate in this wonderful strategy?
To which I received a polite "no comment." I take that to mean they are in a quiet period and something, such as an exchange-traded note, will be launched before the end of the year.