When Is Risk Your Ally In Income Trades?

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Selling puts  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 dividend stocks . 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 ( ETF ) 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 diversification).

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 diversification.

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 investors.

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 contract.

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 time.

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: DIA ) and Chevron (NYSE: CVX ) .

(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 assigned.

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. ( Click here to learn more about calculating returns for put selling trades.)

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 assigned.

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 risk , 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 Reward?



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Stocks

Referenced Stocks: ETF

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