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Tuesday, May 28, 2019

Selling Puts during Low volatility

This article appeared first on enhanced-investing.com
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It is always nice to sell options during high volatility environments. Premiums are higher and you can also position your strikes farther out of the money. However, there are many extended periods in the markets characterized by low volatility. Should we keep selling Puts in those scenarios?

The challenge with the markets is that you never know what comes next. Just because volatility is low it doesn’t mean it is about to go back up. I can think of low volatility years like 2013 and 2017, where, if the low volatility had stopped you, you wouldn’t have done anything all year.

At the same time, the fact that volatility is high, doesn’t mean it can’t keep going up.

So, the way I have learned to deal with this situation is to sell Options (regardless of the market environment) but with very important caveats:
  • Play options on a solid/mature business, whose stock we wouldn’t mind owning in case of a Put assignment.
  • Select strike prices at which, if assigned, the stock would be undervalued, or at least fairly valued.
  • Make your time worth it. Even if the two elements above are present, I may obtain “too little” credit, in which case I skip the trade. I aim for a minimum 30% annualized return on margin. For instance, If a Put option 50 days away from expiration has strike price 60 and it is giving me a credit of $40, I look at how much margin the broker requires for me to carry that short Put (this number will vary from broker to broker). Let’s say for the sake of the example the broker requires $550 in margin (or “buying power”). So, we’re making $40 dollars on $550 margin. That’s a 7.3% return on margin (40/550). Then I annualize it. That return would be obtained in 50 days. So, convert it to a daily return and then multiply it by 365 to obtain the annualized return: (40/550) /50 * 365 = In this case it is a +53% annualized return on Margin. This would be a go. Alternatively you can calculate the return on the entire capital that would be used on an assignment. If the strike price is 60, then the max capital invested would be $6000. In this example we are not using the margin required to carry the Put option but the max buying power on a hypothetical assignment. In this case a $40 return on $6000 divided by 50 days, multiplied by 365. This gives me an annualized return of +4.9%. I would not enter the trade if the annualized projected return resulted in a number smaller than 3% when doing the analysis this way.
The markets are always challenging. No matter the year or the environment. It’s unpredictability requires us to be disciplined and follow a consistent approach. Doing the above in low volatility environments has done well for me over the years. Certainly better than if I had chosen to stay inactive.

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