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The Right Time to Buy Write Options

Steve Smith provides more insights on options hedges.

It's a key investor maxim: never sell short options which would create a "naked" position. These positions expose an investor to theoretically unlimited losses. Moreover, being short the premiums can be dangerous in a volatile market, especially due to the "vega" risk (when implied volatility causes an option sold short to increase in value, resulting in large losses).

But a period of heightened volatility also offers opportunity. I wrote

this article

discussing when it makes more sense to employ a covered call strategy. This should be used when stocks or markets are highly volatile. Since you are going to assume the considerable risk of owning a stock, you should get paid by collecting higher option premiums. This might seem to be counter-intuitive for a strategy that is promoted as conservative and usually applied to steady blue chip names.

This holds true as well for selling puts, which as mentioned have the same risk/reward profile for as a covered call. In fact due to such factors as cost of capital for owning the underlying shares, selling puts can offer a better return on investment.

As described in

this article

the Chicago Board of Option Exchange created the Put/Write (PUT) Index in June 2006 as a sister product to its popular Buy/Write (BXM) index. The difference between the two is where the Buy/Write is "covered." By owning the underlying shares, the Put/Write requires cash as the security or a margin requirement to maintain the position.

Back in


the CBOE approved Ansbacher Investment Management's bid to license products whose performance is based on the PUT.

At the time, I met with Jason Ungar, director of investment for Ansbacher, to walk me through the product and explain how it historically not only outperformed both the S&P 500 Index but also the BMX.

According to Ungar, the key is lies in the skew in the prices for S&P 500 index options Ungar 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. That has certainly been true of late as fear has gripped the market and implied volatility has been driven to five-year highs as investors pay up for out-of the-the money put protection.

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While the Buy/Write and Put/Write both theoretically sell at-the-money options, the underlying index is rarely right at a strike price. That means both essentially sell options that are slightly closer 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 and results in higher returns.

The most recent data confirm that selling puts not only delivers superior returns but also has a lower beta or volatility than owning the S&P 500 Index or even employing the Buy/Write approach.

As of March 20, the Put/Write Index was down just 2.28% for the year to date. This compares to the S&P 500, which was down 8.93%, or the BMX, which was down 3.53% at that point for the year to date.

Also dispelling the myth that naked put selling is the most dangerous game, the beta of the PUT was just 0.48, meaning its value changed at less than half the rate of the underlying index.

This becomes very important in volatile markets in that you are less likely to panic during steep declines. For example the largest drawdown, or paper loss, of the PUT over the past five years has been 29% compared to the

S&P 500 Index

, which faced a 44.73% loss at one point. The put also managed to recover its losses in 21 months compared to 49 months for the underlying index to recoup its losses.

Now all we need is the launch of a tradable product that mimics the PUT. Mr. Ungar of Ansbacher assures me that one is imminent. I'll be waiting to pass along when that happens and what form it takes.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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