While traders can be instinctive and act quickly when necessary, most of us try to analyze a potential position from all possible angles in order to fully understand the potential rewards and risks represented by the exposure.
During this analysis, we may also consider other underlyings, or other positions within the same underlying, that may be preferred over the structure we are considering.
If you’ve previously explored alternatives to long stock, a recent episode of Market Measures may help you further evaluate alternatives to this traditional position. The focus of the show is a side-by-side comparison of long stock vs. a short put.
Obviously, when a trader purchases stock, he/she is hoping that the value of the underlying will increase. For situations in which a trader is expecting a sharp rise in the price of the underlying in the near-term, long stock is certainly one choice available to the trader.
However, there may be situations when different position structures, such short puts, may better fit your outlook and risk profile.
As a reminder, the risk to a long stock position is that the underlying drops (possibly precipitously) and that the trade incurs losses. After such a drop, a decision must be made whether to hold the stock or to cut one's losses and close the position.
When selling puts, the trader is also at risk of getting long stock. If the strike of a short put is breached, and the options are exercised, the short put seller must purchase 100 shares of stock at the strike price for every contract sold.
In this regard, both a long stock position and a short put position, can ultimately end up as the same exposure (long stock). Sizing is therefore extremely important for option sellers because the addition of each contract represents another 100 shares at risk. Aside from a down move in the underlying, short puts can also lose money if implied volatility rises.
But what if a trader envisions a stock sitting still for the foreseeable future? Or at least expects it to trade in a relatively tight range.
In that hypothetical scenario, a trader might consider selling puts as opposed to buying stock, because it may produce a more attractive return on capital for the expected circumstances. Obviously, a long stock position that sits still at best breaks even. A short put under the same conditions can work perfectly, with similar overall exposure (assuming correct sizing).
A short put also comes with a buffer built into the position - that being the premium received from the option sale. For example, if stock QRS is trading for $33, and a trader sells the $30 put with 45 days-to-expiration for $1.50, the position breaks even if QRS drops to $28.50.
On the other hand, if the trader purchased long stock for $33/share in QRS, and the stock drops to $28.50, the trader will lose money all the way down.
One should also keep in mind the reverse situation - if QRS rallies. Under that hypothetical scenario, the long stock position does offer additional potential upside rewards, as compared to a short put. These examples help illustrate why a variety of approaches can be considered - it all depends on what is expected, and the risk profile of the trader.
A natural question to ask at this point is which of the two strategies has performed better over time?
On the aforementioned episode of Market Measures, the hosts walk viewers through tastytrade research focusing on the historical performance of long stock vs. short puts in SPY from 2005 to present. The results of this study can help traders better understand how each respective strategy has performed over that period and may help you deploy positions going forward that best fit your outlook.
It should be noted that the research conducted for this comparison was only in SPY - meaning that it may not be applicable to other underlying symbols, and different time frames.
Due to the importance and complexity of this topic, we hope you'll take the time to review the complete episode of Market Measures focusing on short puts vs. long stock when your schedule allows. On the show, you’ll find the answer to the question regarding which approach performed better, as well some other helpful analytics.
If you have any outstanding questions on this topic, we hope you’ll leave a message in the space below, or reach out directly at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.