in your investment account can be a tremendous strategy for
generating reliable income while taking on less risk than more
traditional income strategies like buying and holding
. The trading approach is made possible by selling a put option
to speculators who either:
1. Think that the underlying stock or exchange-traded fund (
) is headed lower, or
2. Want to hedge their current exposure.
From our perspective as option sellers, one of the most
important decisions is what types of securities to sell puts
against. Specifically, some traders struggle with the decision of
whether to sell puts against individual stocks (which give them a
risk/return profile that is affected by the individual company
dynamics), or against broad indexes or ETFs (which offer more
To determine where you should put your capital to work, let's
look at the driving forces for both risk and returns based on
both of these approaches.
Volatility And Diversification
One of the primary benefits of investing in an ETF as opposed to
individual stock positions is that the ETF gives you instant
However, keep in mind that not all ETFs are as diversified as
you might think. For instance, the top three holdings might make
up 25% of the ETF. But, as a general rule, ETFs can help to
smooth out the risk of individual company performance for
From an academic standpoint, this risk is associated with
volatility. Since volatility can be measured in statistical
terms, it has become industry practice for risk managers to look
at volatility (along with other issues, such as correlation) to
measure the level of risk in individual portfolios.
This measure of volatility is important to us as put sellers
because option prices are heavily influenced by the level of
volatility in the underlying stock or ETF. The higher the level
of volatility, the higher the price of the individual option
Now think about this pricing dynamic in relation to our put
selling strategy for a moment. Higher volatility means more risk
to investors, but it also means more option premium, which is
responsible for generating income in our own portfolio.
Of course, our strategy is not immune to the volatility risks
that individual investors face. This is because when we sell a
put option, we are essentially guaranteeing that we will buy the
underlying stock or ETF if it is below the strike price when the
put option expires. So this means that we will be at risk if the
ETF or individual stock continues to fall.
As with most investing strategies, the more volatility (or
risk) you are willing to accept, the higher your expected returns
will be. Traders who are willing to sell put options on
individual stocks are therefore more likely to receive a higher
rate of income than those who are selling puts against an index
or ETF. There are exceptions, but this is true most of the
A Real-World Example
To illustrate this point, let's take a look at some one-month put
option contracts for
SPDR Dow Jones Industrial Average (NYSE:
(Note: I picked Chevron because it is a widely held Dow
component, and it was recently trading just above a popular
strike price, which gives us a good comparison to DIA. Prices
will no doubt have changed by the time you are reading this, but
this is purely for illustrative purposes.)
At the time of writing, DIA was trading at $159.30 -- or just
above the $159 strike put contract. Chevron was trading at
$120.06, or just above the popular $120 strike put contract. I'm
going to run the numbers for traders who decide to sell the DIA
puts versus traders who sell the CVX puts.
For DIA, the $159 puts expiring one month from now can be sold
for $2. This means that an investor would need to set aside $157
per share of his or her own money, along with the $2 in premium
received in order to cover his obligation to buy DIA if
If the stock remains above $159, the put will expire worthless
and the trader will keep the $2. This represents a 1.3% return
over roughly a month's time, or a 16% per-year rate of return. (
to learn more about calculating returns for put selling
For CVX, the $120 puts expiring in a month can be sold for
$1.78. This means that an investor would need to set aside
$118.22 per share of his own money, along with the $1.78 in
premium he received, in order to cover his obligation to buy CVX
If the stock remains above $120, the put will expire worthless
and the trader will keep the $1.78. This represents a 1.5% return
over roughly a month's time, or an 18% annual rate of return.
Deciding Which Approach Is Best For You
It is important to
look at these numbers within the context of
, rather than simply looking at the raw return data.
In the example above, if you sell puts on CVX, you are opening
your account up to the risk that CVX earnings will be lower than
expected, that oil prices will decline, or that operational
issues cause the stock to trade lower.
All of those risks affect DIA as well since CVX is one of the
components of the Dow, but those risks are muted because of the
diversification from investing in an ETF. Depending on your risk
tolerance, you may feel like the additional few percentage points
are worthwhile and choose to sell the CVX puts.
On the other hand, you may determine that you are happy with
the lower return from selling DIA puts, because your risk is more
diversified with this approach. The key is understanding the
variables for each trade and making an informed decision rather
than looking at expected rates of return in a vacuum.
This article originally appeared at ProfitableTrading.com:
Are Riskier Income Trades Worth the Extra
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