When you mention put writing to someone, their eyes widen, pupils dilate, their brain shuts down and tohu vavohu (Old Testament Hebrew term meaning “chaos” or “pandemonium” and still used in modern Hebrew language) ensues. This article will put right put writing, relieving anxiety, stress and possibly, believe it or not, even make you a fan of put writing. A couple of definitions and explanations are needed first. To begin with, put writing in this article is about “covered put writing”. To make things a little less complicated, the puts discussed in this article are European puts, the cash position earns no interest (i.e., interest rates are zero) and dividends, to the extent they matter, are ignored (i.e., assumed to be zero) Definition 1 : A covered put position is the combination of 1) a short put position and 2) a cash position equal to the maximum loss of the short put position. a) A covered put position is equivalent to a capped long position in the underlying stock. The covered put position will decline in value as the underlying declines in value and will increase in value as the underlying increases in value. b) The maximum amount a covered put position can earn is capped at the premium received from selling the puts. c) The maximum amount a covered position can lose is equal to the maximum loss of the short put position less the premium received from selling the puts. Definition 2 : The maximum loss of a short put position is the put strike times the number of options sold. Here is an example of a covered put position: An investor enters into a covered put position by first selling 1 put option on the S&P 500 Index. The put option strike is 1,880. The investor then allocates a cash position of $1,880.00 to cover his maximum loss. The $1,880.00 cash position is obtained from multiplying the put strike by the number of options sold or 1,880 x 1. This covered put position ensures that even if the S&P 500 Index goes to zero, the investor always will have enough cash to cover any loss when the put options expire and still have the premium from selling the puts. Now that we’ve got the basics out of the way, time to get to the meat of the matter. Below are what I call the ” maxims ” of covered put writing. They may surprise you. Maxim 1: A covered put position, over the term of the put (i.e., before the put option expires), is always a more defensive position than owning the underlying outright. That’s right, always . This is because the premium received from selling the put options provides a “buffer” against a declining underlying. Owning the underlying outright provides no such buffer. Maxim 2: The maximum gain from a covered put position over the term of the put is the total premium received from selling the puts. If the premium received is 2% (as measured as a percentage of the cash position), then 2% is most the covered put position can return over the term of the put, no matter how much the underlying increases in value Maxim 3: A covered put position is theoretically identical to a covered call position where both the puts and calls sold have the same strike . If you’re comfortable or familiar with covered call strategies, then you are, by definition, comfortable with covered put strategies . Covered put positions, however, can provide certain advantages over covered call positions which I will detail later. A Simple Systematic, Rolling Covered Put Writing Strategy All put options have expiration dates. When the put option in a covered put position expires, it must be “rolled” into a new put option with a new strike and expiration date. One simple Systematic Rolling Covered Put Writing Strategy (SRCPWS) is to sell and roll one-month, at-the-money put options. This strategy, it just so happens, is used by the CBOE S&P 500 PutWrite Index (PUT) . This index, which has been in existence since 1986, sells one-month, at-the-money puts on the S&P 500 Index on a monthly basis while investing its cash position in one-month and three-month T-Bills (The CBOE also has a covered call index, the CBOE S&P 500 BuyWrite Index (BXM) There are two listed ETFs available that follow a simple Systematic Rolling Covered Put Writing Strategy on the S&P 500. The first is the ALPS Enhanced Put Write Strategy ETF (NYSEARCA: PUTX ) and the second is the WisdomTree CBOE S&P 500 PutWrite Strategy Fund (NYSEARCA: PUTW ) . Both write one-month at-the-money puts on the S&P 500 every month and 100% collateralize the put options sold by investing their cash positions in either short-term T-bills or short-term investment-grade corporate notes. The Performance Attributes of a Systematic Rolling Covered Put Writing Strategy (SRCPWS) are best described by the “corollaries” presented below. To help illustrate these corollaries, I will use the historical performance of PUT versus the historical performance of the S&P 500 Total Return Index (SPTR). Corollary 1 of Maxim 1 Corollary 1 of Maxim 1 for a Systematic Rolling Covered Put writing strategy (such as implemented in PUT): If the underlying declines in value over consecutive “roll periods” (monthly in the case of PUT), an SRCPWS will never have a more negative return than an outright position in the underlying and will always outperform the underlying. – A corollary to the corollary is that the volatility of the SRCPWS will almost always be lower than the underlying in this scenario. Under this scenario, the premium received from selling options each roll period provides a downside buffer, allowing the SRCPWS to always outperform the underlying. A real life example of this is given in the chart below using the actual performance of PUT and SPTR (monthly data, using third Friday of each month). From 8/15/2008 to 11/21/2008, SPTR declined falling 39.3%. PUT over the same period fell only 30.4%. In addition, the annualized daily volatility of PUT was 54.1% while SPTR’s was 62.7%. Click to enlarge Another real-life example for this scenario is worth presenting and is presented in the chart below. In this example, SPTR had a negative return while PUT’s return was positive. From 12/19/2008 to 3/20/2009, SPTR declined each month, falling 12.7%. PUT over the same period increased 0.6%. In addition, the annualized daily volatility of PUT over this time period was 26.6% while SPTR’s was 38.3%. In this example not only did PUT outperform SPTR, but it also had a positive return while the underlying, SPTR, had a negative return. Click to enlarge Corollary 1 of Maxim 2 What if the underlying increases in value? That’s Corollary 1 of Maxim 2 : If the underlying increases in value over each “roll period” (monthly in the case of PUT), the SRCPWS will always have a positive return but may or may not outperform the underlying. – Again, a corollary to the corollary, is that the volatility of the SRCPWS will almost always be lower than the underlying in this scenario. Under this scenario, the return of the SRCPWS is capped by the total premium received from selling its options each roll period. If the underlying’s performance is less than the premium received, the SRCPWS will outperform the underlying. If the underlying’s performance is greater than premium received, the SRCPWS will underperform. For this scenario (i.e., where the underlying increases) two real life examples are needed. The first example, given in the chart below using the actual performance of PUT and SPTR, is for the case where the SRCPWS doesn’t outperform the underlying. From 3/20/09 to 01/15/2010, the SPTR increased by 50.48%. PUT over the same period increased only 35.19%. In addition, the annualized volatility of SPTR over this period was 69.3% while that of PUT was under half that value at 33.2%. Click to enlarge The second example is for the case where the SRCPWS does outperform the underlying and is given in the chart below using the actual performance of PUT and SPTR. From 1/20/2006 to 4/21/2006, the SPTR increased, steadily, by 4.43%. PUT over the same period increased 4.85%. In addition, the annualized volatility of PUT over this period was 4.97% while the annualized volatility of SPTR was 9.37%, over twice as much as PUT’s. Click to enlarge Of course, underlyings don’t just always go up or always go down. Markets (and underlyings, whatever they may be) may trend up or down, but they almost always are “volatile” around that trend. This brings me to Corollary 2 of Maxim 1. The SRCPWS may recover from a period of negative returns more slowly than the underlying. This corollary is actually a combination Corollary 1 of Maxim 1 and Corollary 1 of Maxim 2 . Corollary 1 of Maxim 1 says the SRCPWS will always outperform when the underlying declines in value while Corollary 1 of Maxim 2 says the SRCPWS may not outperform the underlying when the underlying increases in value. – Again, a corollary to the corollary, is that the volatility of the SRCPWS will almost always be lower than the underlying in this scenario. This makes sense because the return of the SRCPWS during any roll period is capped at the premium received from selling puts while the return on the underlying is not. How much more slowly the SRCPWS recovers than the underlying depends both on 1) how much the underlying increases over a given period of time and 2) the premiums received from selling the puts over that same period of time. The chart below presents a real-life example using the actual performance of PUT and SPTR. The chart shows that from 9/21/12 to 11/16/2012, SPTR declined 6.51% while PUT declined only 3.63%. The chart then shows that from 11/16/12 to 3/15/13 SPTR increased 15.65% while PUT increased 6.17%. Over the entire period, SPTR increased 8.12% while PUT increased 2.32%. In addition, the volatility of PUT over the entire period was 6.73% while the volatility of SPTR was 11.63% Click to enlarge Non-Zero Interest Rates – Treasury Bill or Investment-Grade Short-Term Corporate Note Investment In the beginning of this article, I assumed interest rates were zero to make things less complicated. PUT, however, invests all of its cash in one-month and three-month T-Bills. In this way, the return PUT generates is augmented by the interest income earned on its T-bill investments. Short-term interest rates are at historical lows but have been at much higher levels significantly contributing to the return PUT generated. Because PUT invests in short-term Treasury bills, when or if interest rates rise, the return generated by PUT from interest income will increase. Both PUTX and PUTW invest most of their cash in interest-bearing instruments. PUTX invests its cash mainly in short-term investment-grade corporate notes. PUTW invests its cash mainly in one-month and three-month T-bills. These investments in short-term investment-grade corporate notes or short-term T-bills collateralize (i.e., cover) the put options sold. Volatility, Downside Volatility and Downside Risk Adjusted Return Volatility: As is mentioned throughout this article, an SRCPWS will almost always have a lower volatility than its underlying. For all practical purposes, it’s fair to say that an SRCPWS will always have a lower volatility than its underlying because the change in value of the put option as a percent of the cash position is almost never greater than that of the underlying on any given day. It is possible, though, in unique circumstances for this not to be the case. And if the SRCPWS invests its cash in interest-bearing instruments, it’s also possible they could add to the volatility of the SRCPWS. Below is a table giving the annualized monthly volatility of PUT and SPTR over different time periods. The table shows PUT is about 65% as volatile as SPTR. Downside Volatility : Downside volatility is a measure of the volatility attributable to negative returns. Many investors believe that volatility from positive returns is not relevant to defining the risk of an investment and that the only important volatility is that generated from negative or adverse returns. Because an SRCPWS has an asymmetric return profile (i.e., can have a greater negative return than positive return in a given roll period), comparison of the downside volatility between the SRCPWS and its underlying is important. The downside volatility of an SRCPWS should almost always be less than that of its underlying for the same reason its volatility is almost always less than its underlying. The table below gives the annualized monthly downside volatility of PUT and SPTR. The downside volatility is ca lculated using a minimum acceptable return (MAR) equal to the average monthly return over the relevant time period (the average monthly return is identical to the “mean” used in the calculation of volatility above). The downside volatility of PUT is slightly less than 80% of the downside volatility of SPTR. Sortino Ratio : The Sortino Ratio is the “Sharpe Ratio” for skewed or asymmetric return profiles. It is a measure of the risk-adjusted return for these type strategies. However, many investors believe the Sortino Ratio is better than the Sharpe Ratio for all investment strategies because it does not penalize positive returns when “upside” volatility is high. The Sortino Ratio is calculated in the same way as the Sharpe Ratio but instead of using volatility , it uses downside volatility . Below is a table showing the Sortino Ratio and Sharpe Ratio for PUT and for SPTR. The downside volatility used in the Sortino Ratio was calculated using an MAR equal to the average monthly return over the relevant time period. Both the Sharpe Ratio and Sortino Ratio were calculated using a risk free rate (or target return) equal to the average three-month CMT rate over the relevant time period. This was done for the sake of simplicity and does not affect the comparison. There are two observations of interest. First, the PUT and SPTR Sortino Ratios are greater than the PUT and SPTR Sharpe Ratios for each time period. Second, the PUT Sortino Ratios are less than the SPTR Sortino Ratios in the three- and five-year time periods but are greater than the SPTR Sortino Ratios in the 10- and 28-year time periods. The first observation makes clear that the downside volatility is always less than the volatility for both PUT and SPTR. The second observation reveals that PUT’s risk-adjusted return (as measured by the Sortino Ratio) was worse than the risk-adjusted return of SPTR in both the three- and five-year time periods but better in the 10- and 28-year time periods. This occurred mainly because SPTR’s downside volatility decreased relative to its “overall” volatility in the three- and five-year periods while its return was better than PUT’s. Advantages of Covered Put Writing Over Covered Call Writing Earlier in this article I presented Maxim 3 : A covered put position is theoretically identical to a covered call position where both the puts and calls sold have the same strike . I further stated that covered put writing may provide certain advantages over covered call positions. When comparing the historical performance of the CBOE S&P 500 BuyWrite Index (a covered call index on the S&P 500 Index) and PUT, PUT handily outperforms. The chart below shows the PUT and BXM performance from 3/3/2006 to 3/4/2016: Click to enlarge Over this 10-year time period, PUT outperformed BXM by almost 26%. There are three reasons why this may have occurred: 1) In a covered call strategy, the number of options sold equals the number of shares owned. If BXM owns 100 shares of the S&P 500 Index, then it sells 100 options on the S&P 500 Index. PUT, however, does things slightly differently and, as a result, sells slightly more options. This is because PUT is collateralized by cash or cash equivalents and not shares of the S&P 500 Index. PUT sells a number of options such that the maximum loss (see above for definition) in each roll period is equal to the cash position plus the premium received from selling options. This means PUT takes in more option premium than BMX each roll period and can have greater returns as a result. 2) PUT sells put options that are at-the-money or slightly out-of-the-money. BXM does the same with its call options. However, slightly out-of-the money put options tend to have a slightly higher premium than slightly out-of-the-money call options. This can mean PUT takes in more option premium each roll period. 3) BXM owns shares of the S&P 500 Index and is short call options. PUT is long T-bills and short put options. PUT earns interest on the cash invested in T-bills while BXM earns dividends from its S&P 500 shares. It’s possible that interest income, all other things the same, can be greater than dividend income. Putting It All In Perspective Covered put writing is theoretically no different than covered call writing. If you’re comfortable with covered call writing, then you’re comfortable with covered put writing. Covered put writing may provide better returns that a similar covered call strategy. A covered put writing strategy can be considered a defensive strategy relative to an outright investment in the underlying. A covered put writing strategy is almost always less volatile and may provide better risk-adjusted returns than an outright investment in the underlying There are two broad market covered put writing ETFs available, ticker symbols PUTX and PUTW. Both write one-month at-the-money puts on the S&P 500 every month and 100% collateralize (i.e., cover) the put options sold by investing their cash positions in either short-term T-bills or short-term investment-grade corporate notes. Remember, the S&P 500 Index, the S&P 500 Total Return Index, the CBOE S&P 500 BuyWrite Index and the CBOE S&P 500 PutWrite Index are indexes. You cannot invest directly in an index Jeff Klearman is the Chief Investment Officer of Rich Investment Solutions and a Registered representative of ALPS Distributors, Inc. Rich Investment Solutions is the sub-advisor to the ALPS U.S. Equity High Volatility Put Write Index ETF (NYSEARCA: HVPW ) and the ALPS Enhanced Put Write Strategy ETF. ALPS Advisors, Inc. is the Investment Adviser to HVPW and PUTX, and ALPS Portfolio Solutions Distributor, Inc. is the Distributor for HVPW and PUTX. ALPS Advisors, Inc., ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc. are all affiliated entities. An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, which contains this and other information, call 1-866-759-5679 or visit alpsfunds.com . Read the prospectus carefully before investing. WisdomTree Funds are distributed by Foreside Fund Services, LLC. in the U.S. only. Click here to view or download prospectus for Wisdom Tree CBOE S&P 500 PutWrite Strategy Fund. We advise you to consider the fund’s objectives, risks, charges and expenses carefully before investing. The prospectus contains this and other important information about the fund. Please read the prospectus carefully before you invest. An investment in the Funds involves risk, including loss of principle.
