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TheStockTradingMood:S&P500Simplified:SellingNakedOptionsvsCreditSpreadsinSPY

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Wednesday, October 9, 2013

S&P500Simplified:SellingNakedOptionsvsCredit
SpreadsinSPY

Lately I've been tinkering with credit spreads and naked puts in SPY, more out of curiosity than anything
else... that is until I did some extensive studying of the historical SPY data. More on that another time
though.
I have dabbled in options before and made out very well.... and not so well in varied proportions. The one
strategy that I did have a 100% success rate (albeit with not as many trades as would be needed to prove
feasibility) with was the credit spread. It was short lived due to my need for continued testing of other
strategies and styles of trading, which is now one of those hindsight stories.
The basic credit spread plan is to sell an out of the money option and buy a further out of the money
option with the same expiry. The first is the profit and the second is the protection. The risk is fixed and
is the difference in the strike prices less the premium collected. The trouble is getting enough premium
difference between the two transactions to be profitable which made me consider the naked option.
Naked option selling looks much more lucrative up front as selling the option without the need for a
protective leg purchase means that all of the premium collected is kept. This often allows the sold option
to be farther out of the money and still be profitable. The trouble is that the risk is no longer defined.
With a naked put, if the price plummets the loss becomes the difference between the strike price of the
put and the price of the underlying at expiry. Not that a stock is going to hit zero but a large down move
could be a real problem. This is the point where my SPY study comes in to provide some historical context
for the risk involved.
While the naked options look enticing for the reasons mentioned and the credit spreads look to be a safer
bet, the upfront account management implications for both need to be considered and compared.
Account size.

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A typical broker may have a $5,000 minimum account balance in order to trade credit spreads whereas
$25,000 is required to sell naked options. This makes the credit spread more accessible to the small
account holder or hobby trader. Anyone halfway serious can probably start with enough to choose either
method but only if they are comfortable and confident in the plan and have at least $100,000 would they
really be able to use naked option selling.
Margin requirements.
The credit spread requires the entire potential loss to be in the account... so, technically, margin is not
even being used. With a spread that covers a $1 strike price range, this amounts to about $100 per contract
and the margin does not change with the price of the underlying stock. This is also the entire amount
risked, less the premium collected, on the trade. It will vary with how wide the spread is in increments of
$100 per strike per contract. Because the protective put will be exercised to offset the naked put in a
worst case scenario, there is no chance that there will be any assignment of the stock or ETF.
For a naked option this amount is more variable and is not the entire risk associated with the trade. For a
$100 stock the margin required might be in the $1,500 range whereas a $200 stock could be around
$3,000. It varies with how far out of the money the option is and how much premium was collected for
it. The margin requirements also change with the stock price.
These differences make the credit spread a more viable trading method for those with small to medium
accounts as naked option trades will tie up much more cash per transaction.
For example, a naked 140 put for November expiry sold for 19 cents on September 30th. 10 contracts
would yield $170 after commissions but based on a margin requirement of $24,860 which is an ROI of
0.68%. That is one trade.
A credit spread between 141 and 135 strikes sold at the same time with the same expiry would yield 7
cents net. It would take 42 contracts in one trade to equal the cash return of the naked option using
$25,000. The advantage is that four separate trades could be placed at varied times and dates which could
be at different strikes based on the price movement and these can be staggered in a way to reduce the
chance of a price move producing a loss. Four trades of 10 contracts each that I am currently tracking
are from September 30th, October 3rd, 7th and 8th with 10 contracts per trade which can yield a combined
$200 profit after commissions based on a margin requirement of $23,800 or an ROI of 0.84%.
A quick note, both the naked puts sold and the credit spreads that I track are set up such that they have a
success rate of better than 98% over 20 years. Even then the few times that they were "losers" appear to
have been easy to close before they were a total failure... which is more important with the naked options
than the spreads.
(UPDATE: I am investigating strategies based on historical statistics and current data that will serve to
increase the returns on risk and maybe even increase the probability of the trades being winners.)
Jeff.
Posted by JDMoodie at 9:30 PM

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AboutMe
JDMoodie

I started a blog for sharing trading information...

then I started a bit for writing... so who knows
what I will do next. My daughter tells me I have
ADD because I cannot keep at the same thing for
long.... I think getting a new hobby every year or
so doesn't count though.
View my complete profile

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