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How Simple is a Simple Options Trade? Like all options setups, short puts do involve risk (see risk plot below); however, I won’t spend time covering the details on how this setup works. Instead I’ll assume you have a general knowledge of how to enter and exit a short put position. What I would like to discuss is how we enter such trades, namely, what are the tradeoffs we make in trade selection by analyzing a moderately volatile stock. Trade selection involves choosing the optimal strike price and expiration cycle relative to your trading objective. In this article, I’ll focus on strike selection with a future article looking at the various choices for expiration date. It is interesting to compare the tradeoffs of strike selection from the standpoint of the put being in-the-money (ITM), at-the-money (ATM), out-the-money (OTM), and further OTM. This gives us a comprehensive spectrum to make comparisons, but recognize that the tradeoffs span across the entire option chain. We consciously or subconsciously evaluate tradeoffs at every strike, not only when crossing the distinct boundaries above. The challenge to consistently evaluate and make decisions in a nearly infinite spectrum of trades with a similar objectives was the core problem we looked to solve when developing our options ranker software. Let me share with you at a high-level how this challenge is structured. For this discussion, we will use 3M Corporation stock (MMM), a moderately volatile issue (market beta of 1.15) trading at a 52-week high-low range (as of March 1, 2019 close) of $241.35-$178.62 and a current price a closing market price of $207.39 per share. The Dilemma of Tradeoffs in Strike Selection MMM trading at $207 in the market presents different strike selection choices when writing a put. What drives your selection of a strike price, however, creates an interesting dilemma. For example, if you choose an ITM setup, what is the actual goal, what are the risks relative to the moderate volatility of MMM and what do you give up in comparison to a strike selection that is ATM or OTM? A look at the near-term puts for MMM (March 8 based on the March 1st close for the strike intervals between 202.50 (deep OTM) and 210.00 (ITM), here’s what you would have seen: MMM Mkt$ = $207.39 (March 1, 2019) Strike Price Premium (Bid) Extrinsic Value Position 202.50 0.36 0.36 Deep OTM 205.00 0.77 0.77 OTM 207.50 1.59 1.48 ATM 210.00 3.00 0.39 ITM Moving from deep OTM (202.50) to ITM (210.00) at entry, the premium received increases with each strike. This is a consequence of a bullish outlook. The higher premium for the ITM strike is a product of its extrinsic and intrinsic values. The Curious Behavior When Shorts Puts are ITM With MMM trading a little over $207, we could choose a strike price of $210 to put on a trade slightly ITM. We might do this if we were particularly bullish, in order to capture as much premium as possible. However, when the short put is ITM at entry this places the you at risk of exercise and erodes the premium received from extrinsic value. This raises two interesting questions as to the relative risk of establishing a short that is approximately 2-½ points ITM vs. at or out-of-the money: First, is the higher payout worth receiving an exercise notice prior to expiration – potentially forcing you to purchase the shares? Second, is the trader’s bullishness better expressed in a complementing position or instrument considering the extrinsic value is so severely eroded? Being ITM creates some urgency for the put writer, because the longer the position remains open, the more likely exercise by the holder will take place as the remaining extrinsic value will continue to erode. This can be exacerbated if the stock will soon go ex-dividend. In a sense, the play begins to take on characteristics of a long call vs. a short put. This sense of urgency may be tempered somewhat with a stock of moderate volatility since breakeven (intrinsic + extrinsic) may not be breached. Comparing Greeks Across Strike Selection Let’s now look at the Greeks (Delta, Gamma, Theta) at trade entry for short puts on MMM that are ITM, ATM, OTM, and deep OTM to see how they compare. While the Greeks are not the only tradeoffs to consider across the strikes, it does give us a good picture on how the positions behave and differ from one another. Before we make our high-level comparisons, let’s first define the “ideal” values for each of the Greek parameters. “Ideal Parameters” when Shorting Puts Delta (measures the price change of an option relative to a change in the price of the underlying stock) – usually as premium sellers we’re looking to minimize our delta exposure. This allows us to have less volatility in our position with small moves in the underlying. The exception to this rule is when we’re using short positions ITM or deep ITM as we’re using the position for a directional play. Gamma (measures the options delta exposure to movement in the price of the underlying stock) – Similar to delta, we want the changes to delta to be minimal with small moves in the underlying. Gamma is usually described as a risk (gamma risk) for premium sellers. It is the buyer/holders friend as it provides the leverage. Theta (measures the change in the option’s price relative to time) – This is our primary profitability criterion as premium sellers. We want to see as much theta decay as possible with minimal movement in the stock. Gamma and Theta are strongest pitted against each other. Value of Greeks – Short Put ITM Let’s now look at the Greeks (Delta, Gamma, Theta) for an ITM short put which pay $300 in premium. The values at entry are as follows: Delta– the delta of an ITM short put on MMM shows –0.74 which means that as the price continues to move below the strike price by $1 the put will become $0.74 more expensive to buy back. In other words, the ITM position is closely mimicking the underlying stock and will increase to a delta of -1.0 with the effect of gamma. Gamma– the gamma for the short put that is ITM should move slower than the fall in the underlying stock – somewhere about 0.09. This means a $1 drop in the price of MMM would result in a 0.09 increase in the negative delta, bringing it even closer to parity with the underlying stock. Theta– theta for the ITM short put is 0.065 $/day. Therefore, with no price movement you can expect the position to make $6.50 per day. Theta only erodes the extrinsic value in the option, so we will see the greatest theta ATM and reduced theta with the ITM option here as a lot of the premium is associated with intrinsic value. Due to this, the underlying stock must increase in value above the strike of the option (210) for the option to expire with no value. Value of Greeks – Short Put ATM At-the-money lessens exercise risk for the writer and provides the highest amount of extrinsic value received in the premium. Using the 3M option chain from above with a strike of 207.50 (sold for a premium of $1.59 or $159), the maximum profit received by the writer is $159. The Greeks for this position are as follows: Delta – the delta of an ATM short put would move about –0.491 with the market price. You may already know that absolute value of delta estimates the probability that the option expires in the money. It’s easy to understand why this approximation works in this example as the trader has approximately a 50/50 shot that the option will expire out of the money at expiration. Gamma – the gamma for the short put that is ATM should decrease the delta by 0.1. For the same expiration cycle, gamma will exhibit the largest effect ATM. Theta – theta for the ATM short put, as option’s remaining life decreases, is 0.10 $/d, which is the highest we see across all the strikes . Therefore, ATM short puts provide a significant theta opportunity with a tradeoff of high gamma. Value of Greeks – Short Put OTM For an OTM short put, with a strike of 205 and paying $77 in premium, the Greeks are as follows: Delta – the delta of an OTM short put is about –0.27. As the as underlying stock increases by $1/share we’d expect the short put to lose $0.27 in value which is a unrealized profit for the short put trader. When compared with above, you can see that the trader has a higher probability that the put will expire worthless (approx.. 73%). Gamma – the gamma for the short put that is OTM is 0.08. The gamma risk is reduced as we have more “downside protection” by selecting the put further out of the money. Theta – theta for the OTM short put is $0.094/day, which is less than the ATM option but more than the ITM. This shows how much the extrinsic value erodes when ITM options are selected. Value of Greeks – Short Put Far OTM A further OTM setup makes the likelihood that an exercise will take place is next to nil. Maximum profit is significantly reduced to $36, but the probability of profit is also the highest at c.a. 85% (1 – delta). Again, looking at the deep OTM setup for MMM (say $202.50), the Greeks for are: Delta – the delta of a deep OTM short put is around –0.15, which is the lowest delta across the group giving the highest Probability of Profit and highest downside protection. Gamma – the gamma for the short put that is deep OTM is 0.05, meaning that the delta will not see large swings even if the stock moves against the position gradually. Theta – theta for the deep OTM short put is $0.08/day, which is the lowest profitability we’ve seen for theta decay but still greater than the ITM put which becomes a directional bet. Conclusion Here is a summary of the values discussed in this article according to the position of the short put relative to the underlying stock: Strike Delta Gamma Theta ($/day) Probability of Profit Premium (intrinsic + extrinsic) Premium/Return on Capital ITM 210 –0.740 0.087 –0.065 ~26% $300 Highest ROI ATM 207.50 –0.491 0.099 –0.100 ~50% $160 Moderate ROI OTM 205 –0.272 0.077 –0.094 ~78% $77 Low ROI Further OTM 202.50 –0.145 0.047 –0.075 ~85% $36 Lowest ROI Strike price selection when creating a short put setup dictates potential profit and loss risk potential. In summary: Short put, ITM at entry = highest risk, highest ROI, becomes a directional play Short put, ATM at entry = moderate risk, moderate ROI, highest theta decay Short put, OTM at entry = low risk, low ROI, maintains strong theta and tradeoff with gamma. Short put, deep OTM at entry = lowest risk, lowest ROI, easy to over-leverage if notional risk not properly considered. It’s apparent from the colors in the table, that a common “rule of thumb” for short put trading is to select strikes slightly out-of-the-money. However, I hope this article challenges you to be more scientific in your strike selection, expand your evaluation of key trading criteria, and recognize that the tradeoff of risk and reward is in continuum across the strikes. There’s no one-size-fits-all rule of thumb. In the next article, we’ll explore the tradeoffs of expiration cycles with short puts. I would appreciate your feedback and questions on this article as it will help developing the second part. Drew Hilleshiem is the Co-Founder and CEO of OptionAutomator, an options trading technology startup offering a free options screener that leverages Multi-Criteria Decision Making (MCDM) algorithms to force-rank relevancy of daily options opportunities against user’s individual trading criteria. He is passionate to help close the gap between Wall Street and Main Street with both technology and blogging. You can follow Drew via @OptionAutomator on Twitter.

Definitions: DFA Domestic Balanced Strategy Index: This is a diversified blend of Dimensional US equity indices. The index is weighted roughly two-thirds large cap and one-third small cap, along with a tilt towards value. Indices are hypothetical and cannot be invested in directly. One-Month US Treasury Bills: This is a commonly used proxy for the risk-free rate of return on cash. Stocks are highly volatile in the short term, for example a holding period of one year. The following chart plots all rolling 12 month returns since 1950. This chart tells almost everything we need to know about investing in stocks for a 12-month period. If that’s your planned holding period, don’t do it! Not only will the investment frequently underperform cash, it will lose money. Sometimes a boatload of money with 12 month returns ranging from approximately -50% to +80%! On a year by year basis, extremes are normal. If the investment will need to be liquidated for a lump sum of capital within the next 5 years (i.e. a home down payment, car purchase, tuition payment or a readily available emergency fund), it’s probably best to not place the capital in the market as we can see in the next chart. This chart is less noisy, but there are still periods when stocks have lost money over a 5-year period and even more when stocks underperform cash. For this time horizon, it’s reasonable to keep the lump sum capital in cash. Investors with the willingness to accept risk could consider keeping a modest portion in stocks with the awareness the money could be lost. At 10 years, the advantages of investing in stocks is seen more clearly.However, history shows there is still no guarantee. For example, as recently as the bottom of the 2008-2009 crisis, the DFA index just barely produced a positive return over the prior 10 years and would have underperformed cash. Note that an S&P 500 only investor would have done far worse, losing about 30% of their capital during this period highlighting the benefits of the size and value diversification in our DFA index. Experience teaches that many investors tend to think 3 years is a long time, 5 years is a really long time, and 10 years is an eternity. Yet history shows us that at even the 10-year time horizon, expected return relationships (such as stocks to outperform cash) don’t always materialize. This must be true, otherwise there would be no risk.Investors with a 10-year time horizon before needing to liquidate funds (a frequent example of this is a child’s 529 college fund), should invest a portion of the capital in bonds and cash with plans to increase the amount invested each year. Of course, all of this depends on each individual’s willingness and need to take risk, which is why financial planning is a personalized case-by-case process. It gives advisers the opportunities to help investors achieve their goals wisely and with the least amount of fear and stress in the process. The next chart shows the 20 year rolling returns. Many investors in their 50’s and 60’s don’t think this time horizon applies to them because they envision retiring at age 65. What many forget is that the time horizon for retirement planning is different than oneforpaying for a child’s college education. When a child goes to college, the expected depletion of the account is typically within 4 years. A couple entering retirement usually needs to make the capital last for up to 30 years by taking a series of smaller annualized withdrawals.A child entering the first year of college should typically have very little in stocks while a couple entering their first year in retirement will typically want to have the majority in stocks. We see that there are no 20-year periods where stocks underperform cash for the DFA index since 1950. If a retirement investor follows the conventional approach of a 4% safe withdrawal rate, 96% of the portfolio remains invested each year for growth. Annualized stock market returns are much more stable historically once to and beyond this timeframe with the gap between the best and worst periods ranging from approximately +5% to +19%. Last, study a 30-year periods;the contrast between this chart and the 12-month chart is significant. At the one-year time horizon, it’s hard to justify investing in stocks. At the 30-year time horizon, it’s hard to justify not investing in stocks. Risk for short term capital is volatility of principal, while risk for long term capital is erosion of purchasing power due to inflation. Good financial planning considers the time horizon for each objective and invests the need capital accordingly. Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.

This is important not only if you hold equity positions (for covered call writing, for example). Option premium is richer for some underlyings than for others, for a good reason. Higher premium points to higher volatility. In other words, higher risk. No matter what forms of option strategies you employ, picking the underlying is always a reflection of your risk profile. If you are like many options traders and you rarely if ever consider the stock and the company, you could be exposing yourself to higher risks than you intend. The fundamental test Risk is not limited to option moneyness or implied volatility. It is not limited to historical volatility of the underlying either. These are all technical tests. Of equal importance are fundamental tests. Options traders often are obsessed with risk, but they might not even consider the origins of risk, the company and its fundamentals. Fundamental volatility is worth checking and comparing. If a company experiences rising revenue every year and consistent net returns, this is a reliable trend and volatility is low on the fundamental side. If a company sees erratic changes each year, from high net return to a net loss, and from rising revenues to falling revenues, that is a signal of higher risk. Even though this seems far removed from option valuation, it affects the entire options market directly. Five key tests of the fundamentals should be performed over a 10-year period, using the CFRA reports provided by most large brokerages. These define fundamental volatility and translate to how much risk you face in trading options: Dividend yield and history. What is the dividend yield and how has the trend evolved? Many exceptional companies pay 3.5% to 5.0% dividend and see equally strong priced growth over time. Select high-dividend stocks for improved reliability in price. A second test is the number of years the dividend has been increased. Many companies have increased dividend per share and dividend yield every year for 10 years or more. These so-called “dividend achievers” tend to perform over time far above market averages. Dividends matter to options traders, especially those using strategies like covered calls for which equity positions are held. Dividends often represent a substantial portion of overall return from trading, and should not be overlooked in favor of other tests such as high option premium. P/E ratio range per year. The current P/E ratio is meaningless by itself, because it reflects the current value and not the typical value. Because P/E compares a technical factor (price) to a fundamental factor (earnings per share), the timing is always off. Price is the price today, but earnings are reported quarterly and may be out of date at the moment. For this reason, the best way to check P/E is the annual high and low levels over 10 years. Look for companies with low volatility in P/E. The moderate range between a high of 25 and a low of 10 indicates that the pricing of stock is reasonable. Revenue growth. A well-managed company should see higher revenue year after year. This is difficult to accomplish over a 10-year period, so some flexibility is necessary. The cyclical nature of many sectors makes it practical to look at overall growth and not to demand that every year’s revenue should rise. Earnings growth and net return. There are two key earnings test. First, look for the dollar amount of earnings to increase each year. Second (and more important), check net return. This is the dollar amount of earnings divided by revenues. Expect to see a consistent net return over many years. A growing net return is not realistic; but the combination of higher dollars of net and consistent net return define good management. A company whose revenues are rising but whose net return is falling, is not being well managed. Debt to total capitalization ratio. This might be the most important of all fundamental tests. Total capitalization consists of long-term debt plus net equity. The ratio tracks the debt portion. If this is rising year after year, it is a red flag, indicating poor cash management and trouble in the future. As a company relies more on debt to fund dividends and future growth, less future profits will be available. Most cash management testing relies on the simple current ratio (comparing current assets to current liabilities). This is an inadequate test than can be easily manipulated by planning the timing to pay liabilities. It hap[pens too often that a company declares higher dividends and pays for those dividends by accumulating ever higher long-term debt. Look for companies with steady or declining debt ratios and avoid those with ever higher debt year after year. The testing of fundamentals as a first step in picking stocks for options trading is the only way to ensure that an options program is a sound match for the trader’s risk profile. Too often, options traders express disdain for the fundamentals, thinking of them as outdated and of no use in setting up an effective trading program. Those same traders often are perplexed when trading profits fail to materialize. By controlling the fundamental risks (volatility) by the companies selected for options trading, the historical volatility of stock and implied volatility of options will be a good match for your risk profile. If you prefer high-risk in speculative issues, pick fundamentally volatile stocks; but if you seek consistency and moderate stock and option volatility, look for the same characteristics in the fundamentals of the companies you pick for options trading. Ultimately, a successful options program cannot be random or based on picking high-risk strategies on highly volatile underlyings. The relationship between the fundamental side and the technical (stock prices) determines the risk level in the options traded. Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.