Why Options Get a Bad Rap

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Barron's options reporter Steven Sears made a bold trade recommendation to the masses. In the latest issue, Sears' Striking Price column suggested that bullish investors sell put spreads on the SPDR 500 Trust (SPY). The idea is to collect a bit of premium by writing puts on the "Spiders", but also hedge the bet by buying a lower-strike put. It's a position that has a high probability of success, but could also wipe an investor out if market conditions suddenly change.

Stephen Solaka of Belmont Capital was the source of Sears' latest trading suggestion. According to the piece,

"With the SPDR S&P 500 ETF Trust (ticker: SPY) at $138.83, Solaka likes selling the June $128 put, and collecting 95 cents, and buying the July $110 put for 41 cents. The vertical put spread--which is the name of the strategy--generates a 54-cent credit."

Sometimes called Spiders, SPY is one of the most active exchange-traded funds today and, like the S&P 500 itself, holds five hundred of the largest publicly traded companies ranked by market value. It can be used as a barometer for the performance of the stock market and also as a trading vehicle via its shares and options.

SPY is down $0.52 to $139.87 Monday morning. The aforementioned June 128 put is now 8.5% out-of-the-money. The Barron's idea is to write the $128 puts on the view that SPY will hold above that level through the June expiration over the next 46 days.

Writing out-of-the-money puts on index products is not a new idea. Indeed, over the years, many hedge funds and other pros have been active sellers of downside puts on the Spiders, S&P 500 Index (.SPX), S&P 100 Index (.OEX) and other indexes and exchange-traded funds. Over time, the strategies generate income and capitalize from the fact that most downside puts expire worthless. The probability of success is relatively high. For example, the delta of the June 128 put on the Spiders today is only -0.13. Therefore, the probability the contract will expire worthless is roughly 87% (1 - 0.13).

You don't often hear about risks and rewards of index put writing until there is a serious market downturn or crash. At that time, you don't need to look far to find reports of some high flying hedge fund or trader getting wiped out because they were selling naked puts on the stock indexes. Losses from one bad trade can wipe out gains from many months of winning put writes. The risks are high and, for that reason, only customers with deep pockets and much experience in options are allowed to sell puts on the index products with most brokerage firms today.

To hedge the risk of writing June 128 puts, Sears recommended that investors also buy a July 110 put. "If SPY dips below $128 before June expiration, investors are assigned the SPY exchange-traded fund, which includes the 500 largest U.S. stocks. That risk is contained by the July $110 put."

Indeed, buying the deep out-of-the-money $110 put for $0.41 will limit the risk (and margin required) for writing the $128 put at $0.95. However, the downside protection really doesn't come into play until SPY falls towards $110, or a market plunge of 21.4%. What the article fails to inform us is that the risk to the spread is equal the difference between the two strike prices minus the credit collected, or $18 - $0.54. Therefore, the investor is risking $17.46 to make $0.54. Or, on one contract, $54 in premium is collected and the potential risk is $1746.

Most firms are probably very willing to take the other side of a short put spread on the SPY because buying out-of-the-money put spreads is a popular way to hedge "tail risk" or to protect portfolios from a significant market decline. In addition, an out-of-the-money put spread, if bought, takes advantage of skew and the fact that deep out-of-the-money puts have higher levels of implied volatility relative to at-the-moneys or near-the-moneys. For example, implied volatility in the June 128 puts on SPY today is 21.7%, compared to 31.7% for the June 110s. Experienced spread traders prefer to sell the high IV and buy the low IV, not vice versa.

In sum, a July 110 - June 128 put spread on the Spiders for a $0.54 credit is a high probability trade because it is unlikely that the US equity market will decline by 9% through mid-June. There is a good chance that the June 128 put will expire worthless and the strategist can keep the credit. They can then hold the July 110 puts or sell it to salvage any remaining value at the June expiration. Even if the market declines by 5% to 8%, the trade is a winner. However, the typical Barron's reader might not fully understand the risks associated with the strategy. It would probably be a very unpleasant experience, for example, to write ten of these spreads and collect $540, then 46 days later find themselves saddled for a loss of $17,460 if the market tanks. It's these types of trades that get people in trouble during downturns or crashes, and that give options a bad rap within the investment community.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.

At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.

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