Is Option Trading Too Expensive? (Part 1)

My belief in trading naked puts (NP) goes back to some early posts I wrote on the topic. Occasionally, however, I am blinded by an illusion that suggests the trade is too expensive.

Consider the following SPX (S&P cash index) example. On 5/9/2016, with SPX ~2060 I could sell a Jun 1790 put for $2.13. This is 39 DTE and has roughly a 100% probability of profit based on the current implied volatility, which means its expected return is $213. This trade would cost $178,787 in a retirement account. On the same date, with SPY ~206 I could sell a Jun 200 put for $2.05. This is 40 DTE and has a roughly 82% probability of profit. This trade costs $19,795. The first trade is nine times as expensive as the second trade and potential profit for both trades is about equal!

Making matters seemingly worse is the annualized return of the initial trade: only 1.4%. If I wanted to aim for 1% per month then I could sell an option worth 1% of its strike price like the Jun 2010 put for $20.75. This has an 81% probability of profit and an expected return of $604.

[As an aside, if it were possible then buying 100 shares of long SPX would have a lousy 52% probability of profit and an expected return of negative $892. Score one point in favor of options over stock.]

At first glance above, trading the naked put did seem quite expensive but it’s less expensive in the second example.

I believe option trading is better understood as a give-and-take across different parameters. The second trade makes more money but wins less frequently. The first trade will win almost every time but make less money per trade. When the former position does lose, it may indeed be catastrophic. This is not as much the case for the latter. More (less) consistency will be met with (less) more severe, albeit rare (and more frequent), drawdowns.

I will frame this in a slightly different light next time.