Vertical Spread Vs. Naked Put

[JSOP]

if you are worried about crash buy VIX calls which will pay
when
spx
crashes

yeah but that's like hedging for fat-tails as advocated by Nassim Taleb. Yes when a crash does happen, you get rewarded like being in heaven but for ALL the time when it doesn't, you just keep incurring losses after losses after losses after losses after losses...which after a while feels like being in hell.

So between one extreme of incurring huge losses to protect against crashes that happen once in a blue moon and another extreme of having zero protection against any crashes that come along, you take a happy medium where you get some protection against catastrophic crashes but you don't take on huge losses for doing so either: Verticals. I find that's the best. Verticals WILL cut into profits but when catastrophic crashes happen, you are protected. Had this guy in the article traded verticals instead of naked, he wouldn't have lost everything and taken on additional debt of $500K+ which in today's dollars is over $1 million!!

 

[JSOP]

Yeah, the thing about selling naked is that you really can't (reasonably) model possible losses. Sure, it can only go to zero (if NPs). But zero can be wayyy down there. Especially with indices. $300 to almost $12,000. Ouch.

...Around Oct. 1, when the S&P 100 index was about 320, a put to sell the index for 305 was trading in the 3-to-5 range -- $300 to $500 for a standard option on 100 shares. By Black Monday, two weeks later, the S&P 305 put was worth $11,800, and investors who sold them for $300 to $500 had to make up the difference.

Imagine if SPX REALLY went to zero on that day. I think half of the country would've gone bankrupt and owing money to the few that bought put and they would own half of the country!! The drop on that day was just 22% and the price of the put already increased $11495 assuming the original price was 305 so a drop of 100% would've entailed an increase of $52250 assuming vega and IV (which could increase infinitely in theory) remain unchanged and the guy would've incurred a loss of over $5 million+!! And that is assuming that he only shorted ONE contract. Imagine if he had shorted more... And that is just ONE person now imagine the entire industry... If there were buyers, there must've been sellers and I dunno how many of them hedge...

 

[destriero]

I think the S&P 500 will not drop by more than 10% By February 19th, 2021. $SPY at close was $378.77. 90% of this is $340.89.


There are three ways I consider trading this:

1. Sell a Put vertical spread at 340 to 335, currently at $4.68. Max profit: $32, Collateral: $500.
2. Sell a Naked Put at 278. Currently $0.32, Margin Required: $2,812.
3. Sell a Naked Put at 340. Currently $2.05, Margin Required: $3,888.60

Suppose I have $12,000 I would like to invest:

1. Sell 24 spreads, for a max profit of $32*24 = $768.
2. Sell 4 contracts ($2812 * 4 < $12,000), for a max profit of $128.
3. Sell 3 contracts (3,888.60 * 3 < 12,000) for a max profit of $615.


My question is : why would anyone sell naked, when the margin requirements are so high? It seems like you would never be able to deploy your capital if you had conviction about where the price was going. Choice 2 is enormously safer than Choice 1, but has the same payoff if correct. Choice 3 is At the same strike as the short leg in 1, but still cannot return as much. Why do people suggest trading naked? The super safe choice has terrible return. The super risky one has worse return than the spread.

1) Your req is $468, not $500.
2) You're making $768 but risking $11K.
3) Terminally, at 335 your busto in your vertical.
4) Terminally, at 335 you earn $128 on the short 278 put.

The haircut it to protect you from yourself--but then you've found verts and ironically will risk it all on an arbitrary stop (340).

 

[JSOP]

Imagine if SPX REALLY went to zero on that day. I think half of the country would've gone bankrupt and owing money to the few that bought put and they would own half of the country!! The drop on that day was just 22% and the price of the put already increased $11495 assuming the original price was 305 so a drop of 100% would've entailed an increase of $52250 assuming vega and IV (which could increase infinitely in theory) remain unchanged and the guy would've incurred a loss of over $5 million+!! And that is assuming that he only shorted ONE contract. Imagine if he had shorted more... And that is just ONE person now imagine the entire industry... If there were buyers, there must've been sellers and I dunno how many of them hedge...

Oh I have a correction to make: The guy did NOT just sell ONE contract. He actually shorted 72 contracts at two different brokers. Way too overleveraged also. Guess he didn't do scenario analysis either.

 

[stochastix]

yeah but that's like hedging for fat-tails as advocated by Nassim Taleb. Yes when a crash does happen, you get rewarded like being in heaven but for ALL the time when it doesn't, you just keep incurring losses after losses after losses after losses after losses...which after a while feels like being in hell.

So between one extreme of incurring huge losses to protect against crashes that happen once in a blue moon and another extreme of having zero protection against any crashes that come along, you take a happy medium where you get some protection against catastrophic crashes but you don't take on huge losses for doing so either: Verticals. I find that's the best. Verticals WILL cut into profits but when catastrophic crashes happen, you are protected. Had this guy in the article traded verticals instead of naked, he wouldn't have lost everything and taken on additional debt of $500K+ which in today's dollars is over $1 million!!

Absolutely I concur, its very important to do that.. when I first started trading options I did not know that and I nearly got scalped.. but I wasn't that leveraged so I managed the position then learned about verticals..

 

[shawnaboyd]

The profit would have been less if you decided to sell 3 or 4 vertices. Always better to sell naked for this reason.