Deleveraging Put Verticals (Part 1)

This post represents a meandering of thoughts about trading put verticals in reference to naked puts and position sizing.

As a starting point, consider selling a naked put on SPX on September 1, 2016. With the index at $2,166.20, I could sell one SepWk2 $2,125 put for $4.50. The Reg T margin on this would be $2,166.20 – $4.50 = $2,161.70. Were the option to expire worthless, the ROI would be ($4.50 / $2,161.70) * 100% = 0.21%. Since that option expires 10 days later, the annualized return would be ($4.50 / $2,161.70) * 100% * (365 / 10) = 7.60%. At expiration, the trade would be profitable down to $2,125 – $4.50 = $2,120.50, which represents [($2,166.20 – $2,120.50) / $2,166.20 * 100%] = 2.11% of downside protection. This means the trade loses money only if SPX has fallen more than 2.11% at expiration.

I believe it’s never a bad thing to make money when the underlying drops a little or remains unchanged.

On this particular trade, my maximum loss at expiration would be [($2,166.20 – $4.50) / $2,166.20 * 100%] = 99.79%. This is better than buying the underlying, which could conceivably lose 100%. I feel the real power in this trade is being able to repeat it 26 times (for example) per year in which case my maximum loss would be [($2,166.20 – ($4.50 * 26)) / $2,166.20 * 100%] = 94.6%. Over the course of 20 years I would look to work that cost basis down to zero, and, in effect, get my money back completely. But I digress…

One thing I could do to enhance the return would be to sell a put vertical spread rather than a naked put. This could be done with purchase of a long put at a strike price below the short put strike. Were I to buy a SepWk2 $2,100 put for $2.35, my net credit would be $4.50 – $2.35 = $2.15. My Reg T margin, however, would now be $2,166.20 – $2,100 – $2.15 = $64.05. My credit, therefore, would only be $2.15 / $4.50 * 100% = 47.8% of the original. My margin, though, would only be $64.05 / $2,161.70 * 100% = 2.96% of the original! My ROI would be $2.15 / $64.05 * 100% = 3.36%, which represents 3.36% * (365 / 10) = 122.52% annualized. That is bookoo bucks!

Before getting too excited, let’s get back to maximum loss considerations for the sobering reality. My maximum loss at expiration would be (100% – ROI) = 96.19%, which is better than the 99.79% were I to sell the naked put. My downside protection here would be [$2,166.20 – ($2,125 – $2.15)) / $2,166.20 * 100%] = 2.00%, which is a bit less than the naked put. If SPX were to drop to $2,100 or below at expiration then I would realize that maximum loss of 96.19%.

And therein lies the rub! With the naked put, SPX would have to drop 100% (to zero) to force me out at maximum loss. With the put vertical spread, SPX would only have to fall ($2,166.20 – $2,100) / $2,100 * 100% = 3.15% to force me out at maximum loss.

I will continue next time.