Options Trading: Choose Your Own Adventure

We’ve talked about this before. Selling put options can be a tremendous strategy for generating reliable income.

One reason is because, as we’ve explained, you can take on less risk than you can with more traditional income strategies. But this is true only if you execute the options strategy properly.

As option sellers, one of the most important decisions is what type of securities to sell puts against.

Specifically, some traders struggle to decide whether to sell puts against individual stocks or against broad indexes or ETFs. To determine how you should put your capital to work, let’s consider the benefits and drawbacks of both of these approaches.

Volatility vs. Diversification

One of the primary benefits of investing in an ETF is instant diversification.

However, keep in mind that not all ETFs are as diversified as you might think. For instance, the top three holdings might make up 25% of the fund. But as a general rule, ETFs can help to smooth out the risk of individual company performance for investors.

From an academic standpoint, this risk is associated with volatility. Volatility can be measured in statistical terms.

It has become industry practice for risk managers to look at volatility (along with other issues such as correlation) to measure the level of risk in individual portfolios. (There are problems with this approach, which we outlined here.)

This measure of volatility is important to us as put sellers. That’s because option prices are heavily influenced by the level of volatility in the underlying stock or ETF. The higher the level of volatility, the higher the price of the individual option contract.

Now think about this pricing dynamic in relation to our put-selling strategy for a moment.

Higher volatility means more risk for investors. But it also means more option premium. And that, of course, is responsible for generating income in our portfolio.

Put-selling strategies are not immune to the volatility risks that individual investors face. This is because when we sell a put option, we are essentially guaranteeing that we will buy the underlying stock or ETF if it is below the strike price when the put option expires. So this means that we will be at risk if the ETF or individual stock continues to fall.

As with most investing strategies, the more volatility (or risk) you are willing to accept, the higher your expected returns. Traders who are willing to sell puts on individual stocks — rather than indexes or ETFs — are more likely to receive a higher income. There are exceptions, but this is true most of the time.

Stocks Or ETFs? Deciding Which Approach Is Best for You

To illustrate this point, let’s consider a practical scenario. Say we are looking at one-month put option contracts for SPDR Dow Jones Industrial Average (NYSE: DIA) compared with a widely-held Dow component like Chevron (NYSE: CVX).

We could run through the numbers involved with various trade scenarios, but that’s beside the point. It is important to look at the numbers within the context of risk, rather than simply looking at the raw return data.

In this example, if you sell puts on CVX, you open your account up to several risks. CVX’s earnings could be lower than expected, oil prices may decline, or operational issues could cause the stock to trade lower.

All of those risks affect DIA as wellbecause CVX is one of the components of the Dow.

However, the diversification of DIA mutes those risks.

Depending on your risk tolerance, you may feel like the additional few percentage points are worthwhile and choose to sell the CVX puts.

On the other hand, you may determine that you are happy with the lower return from selling DIA puts because your risk is more diversified with this approach.

The key is to understand the variables for each trade. Make an informed determination rather than looking at expected rates of return in a vacuum.

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