Naked Puts (Part 6)

The third observation I made in comparing performance identified much greater consistency with the naked puts than the long shares trade.

The greater consistency can be seen in terms of the straight blue line that moves in a narrow range relative to the jagged red line that moves in a wide range.

An even better illustration of this is seen in the drawdown (DD) graph. The blue line spends most of its time near the top ($0) whereas the red line does not. More specifically, the long shares are in DD for 3033 trading days (~82% of the time) vs. 1827 trading days (~49% of the time) for the naked put trade.

Psychologically, “days in DD” is a very important measure of trade consistency and how likely I am to stick with the strategy. When in DD I feel something between “slightly annoyed” or “not overly happy” to despondent, angry, sleep-deprived, and freaking out. The excruciating psychic pain that forces me to cash out at catastrophic loss happens while in DD. When not in DD, my account equity is reaching new highs. These are times I feel happy and on top of the world.

To better understand the naked put trade, I started out with an apples-to-apples comparison based on capital risk. Clearly while capital risk is the same, risk in terms of DD over the years is not. Once I determine my risk tolerance, capital allocation to the long shares would have to be much smaller than for the naked put trade to equalize the DD.

Put another way, for comparable levels of DD I am able to do the option trade in greater size than the long shares. This is not a surprise when we think about options in terms of leverage. What I find ironic is that people often say options are excessively risky because of their leverage. Here it becomes clear that only by increasing the option leverage can we get comparable risk, which completely flies in the face of “common wisdom.”