Options Theory: Building a Naked Put Selling System

This month’s Trading Justice newsletter spotlighted the mighty naked put strategy. The quirks of the trade were fleshed out in vivid detail, so I can’t recommend reading it enough. Within the tantalizing tale, the CBOE PutWrite Index was introduced. It’s a strategy benchmark index worthy of emulation. But one must understand before he can implement. Since I have a love for all cash seekers in the land, today’s message is my attempt to help you fully appreciate the goodness of the naked put that’s modeled in this fascinating Index.

First, allow me to apologize for the ridiculous level of synonyms that exist in the trading arena. While it’s a beast for new traders to wrangle the numerous names, it does at least provide some variety for those of us who write about them daily. Naked puts are known as short puts or selling puts. And since selling is sometimes called ”writing,” the strategy is also known as writing puts. This last explanation is why the CBOE decided to call their strategy benchmark that tracks the systematic selling of puts on the S&P 500 by the same name.

If I were the chief of marketing, I would have surely thrown “naked” in their somewhere. It’s the ultimate eye-grabber. At any rate, here’s the gist of the Index as explained by CBOE:

“The PUT strategy is designed to sell a sequence of one-month, at-the-money, S&P 500 Index puts and invest cash at one- and three-month Treasury Bill rates. The number of puts sold varies from month to month, but is limited so that the amount held in Treasury Bills can finance the maximum possible loss from final settlement of the SPX puts.”

Let me simplify this a bit. First, the index sells one-month, ATM puts on SPX. Then it rides to expiration with neither profit target nor stop loss, allowing the puts to settle. Finally, a new one month put is sold. Rinse, wash, repeat. As for the invested cash part, that means this is tracking a cash-secured short put, not a naked put. So the Index isn’t using any leverage.

The best way I know of to fully illustrate the advantages to systematic put selling is comparing PUT to buying and holding the S&P 500. Take a gander and see if you can spot at least three differences between the performance of both strategies.

Here are my top three takeaways.

First, selling puts on the market prints profits over time. It’s a money winning strategy, in other words. One that boasts a positive edge that will eventually deliver the dough if you but stick with it. Some shortsighted traders forget about this and abandon ship in the midst of a drawdown.

Second, options provide a more pleasant path to gains. Specifically, selling puts provides a better risk-adjusted return than buying stock. That means you experience far less volatility along the way. The net result is sweeter dreams and fewer ulcers.

Third, this is an incredibly simple strategy. No hedging or micromanaging needed. Its ongoing profitability was a function of three things — the upward drift of asset prices, the overpricing of options, and consistency.

If you’ve ever wondered what a naked put trading system looks like, wonder no longer. This is it.