30 June 2009

Put Spreads - How to Blow Yourself Up In One Easy Lesson

Original Content Sigma Options


My last few posts have been concentrating of naked puts, the main point I've been trying to get across is that they no more risky than anything else, less so, in fact. But we've seen that they can indeed be a weapon of mass wealth destruction if the trader uses inappropriate levels of leverage.


A suggestion that came up as a safer alternative for a straight out premium collection trade is the bull put spread. In principle, I agreed with the suggestion, but with a few caveats.

  1. Proper money management/position sizing is used.
  2. Reward versus risk is commensurate with the probability of win/loss.
  3. Be careful of correlation with multiple positions.

Even though the bull put spread is perceived as a safer strategy than naked puts, it is not necessarily so, if our old friend leverage is used inappropriately. I would argue that bull put spreads may even be more dangerous than naked puts, depending on the margin requirements of individual jurisdictions and brokerages.

There was an option "education" firm (and I use that term very loosely) in Australia promoting bull put spreads as a panacea for wealth building. The chap even gave it a new name... his name - The ######### Strategy (I have no wish to publicize this rubbish) - how's that for marketing nonsense?

I don't have a challenge with bull puts, 'cept that they aren't appropriate at all times. To borrow a point from Ecclesiastes 3, there is a time for every strategy. The most odious feature of our ersatz options guru is the money management and position sizing algorithm whereby most, if not all of the trader's capital is put at risk in the market. This is spread across four or more positions, but the dearth of tradeable options on the Australian market means there is a very high degree of correlation in optionable stocks.

Every boat rises with the tide, as neophyte bull put traders thought that the Holy Grail had been found at last. That is until the arrival of last year's bear market. Those slow to react, in denial or too green to know what to do next were completely wiped out.

Once again, the fault is not the strategy, the fault is leverage... and fighting the tape.


Mark Wolfinger said...

As much as a prefer put spreads to selling cash-secured naked puts, it's so easy to trade too much size.

That's the warning I try to issue every time I mention this strategy:

Size kills!

Wayne said...

"Size Kills"

Yep, I think it's a gaping hole in many option tomes.

As much as I despise the likes of Che Guevara, this (slightly altered) quote seems apt.

"At the outset, the essential task of the options trader is to keep himself from being destroyed."

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