Equity and Index Options Explained

17

Selling Naked Puts versus Selling Put Spreads

Following on from the answer to part (6) in Exercise 16.1, let's now compare selling naked puts to selling put spreads. Specifically, let's compare selling Sep 500 puts naked to selling Sep 500/460 put spreads. The rationale for the two trades is the same, a view that the Sep puts are overpriced (because market volatility is currently too high) and/or a view that the underlying BP share price will not fall between now and expiry. Remember that, in practice, the starting point for long vertical spreads such as long call spreads and long put spreads is usually a directional view. Volatility and its effect upon the price of the options are likely to be secondary considerations. Specifically, relatively high volatility is deterring us from buying outright calls or outright puts.

In the case of short vertical spreads such as short call spreads and short put spreads, it is likely that the primary driver behind the trade will be option prices. Specifically, our starting point is likely to be the view that options are too expensive because we believe that market volatility is currently unjustifiably high. As a result, we know that we want to be short of options. The exact choice of which options to short will depend upon our view on the underlying market. Consider the following decision-making process.

We are speculators in BP options. We believe that all BP options are currently overpriced. We know that we want to sell BP options. Which ...