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In one of his last books Jack D. Schwager suggested that selling equity puts can be a good business. The puts are like insurance policies against market downturns and there is a natural demand. Therefore, he who sells puts (w/o any directional bias) should expect to be compensated for bearing the risk.

There is a chance of getting wiped out, but that risk can be hedged easily. Do you think an individual investor could do it and earn so much that it beats keeping the money in a savings account.

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  • $\begingroup$ Could you please say which of Schwager's books? Thanks! $\endgroup$
    – Shahar
    Sep 15 '14 at 22:57
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If by an individual investor you mean something like the average investor, then the answer is an unequivocal no: first of all, the average investor probably cannot sell put options. In order to sell put options, you have to be very experienced and climb up the option trading approval levels.

Second of all, there is no such thing as risk that can be hedged easily - not if you want to keep the profits that you're going through all of this trouble to earn. And this brings me to my third point: what exactly would be this investor's strategy? How would she hedge the risk? Where exactly (i.e. at what price / time / conditions) would she write the options? And which options: on what security, at which strike price, at which expiration? When (again, under what conditions) would the trade be closed? Would the option be held till expiration, whether in or out of the money?

I have no doubt that many option traders have good answers to these questions. However, with all due respect, I am not sure that the average investor even understands some of these questions. So no, for the average investor, selling put options without a game plan is not a good idea.

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  • $\begingroup$ The strategy is to sell put options on some liquid stock or equity indixes. The hedge is to buy put options at a lower strike and assume only part of the downside risk. I assumed that any investor can do it as long as he is able to post margin. $\endgroup$
    – James
    Sep 15 '14 at 19:45
  • $\begingroup$ That's a little bit better: what you are referring to is called a Bull Put Spread (or a Credit Put Spread). Still, how do you choose the stock/ETF, determine the option's parameters, and time the trade? How is this better than simply buying the underlying and setting a stop loss? Just to be clear, I am not saying there aren't advantages to this approach; in fact, there are. But there are also disadvantages, so it's not necessarily the first trade or investment I would suggest "an individual investor" do. $\endgroup$
    – Shahar
    Sep 15 '14 at 22:56
  • $\begingroup$ The idea is to sell insurance for any stock or index where there is large demand for downside protection. While taking a position in the underlying may look similar or even have the same greeks, it doesn't express the idea behind the trade as well as doing it with options. Say, if I buy the underlying with a stop loss and it stays at the same level then I, fairly enough, earn nothing because I never promised to hedge someone's downside risk with my position. $\endgroup$
    – James
    Sep 15 '14 at 23:42
  • $\begingroup$ How can one tell which stock/index would have a particularly "large demand for downside protection"? My point is that there are multiple strategies and they are all different (I don't think anyone uses greeks for underlying equity positions - and if they would, those greeks would never be the same as the option's). I still see no overall motivation as to using this particular [bull put spread] strategy over anything else. And if one does not know what he's doing, he'd be better off staying away from any option strategy. $\endgroup$
    – Shahar
    Sep 16 '14 at 0:03
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It is the opposite of Taleb's advice. There is no single answer on that, but one could say you are exposing yourself to potentially deadly risk. I bet you did not want to be in that position in October 1987, dot-com bubble, during the latest crisis or any "Black" day.

You can hedge that risk, but it also diminishes your return. You can hedge by either using the underlying or another option (bull/bear spread?). Given the volatility smile, the deeper out of money will have higher IV therefore comparatively be more expansive. Add the friction (transaction costs) and your strategy can be worthless.

But true, given today's "risk-free rates" it will probably beat savings account for some time.

Last word. Past data shows that increases in the asset value is more likely to be gradual but decreases are sudden and drastic.

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  • $\begingroup$ No it isn't the opposite of Taleb's advice. Regardless of whether you agree with Taleb (I don't), what Taleb does (or did, I'm not sure his fund survived the past 5 years) is buying very deep otm puts, where he argues they are deeply undervalued because people make the wrong assumption on market dynamics. One type of retail option strategy (and I'm not recommending this, not advising against it) is selling (typical tight) short dated spreads to enhance income (typically, but not necessarily done in the form of a condor). The benefits of tht type of strategy are unrelated to what Taleb preaches $\endgroup$
    – Bram
    Sep 16 '14 at 0:44
  • $\begingroup$ I believe there is merit in Taleb's advice, but it is not a satisfying investment strategy. Bleeding out to get an ambiguous big win at an unknown time is not the most assuring thing for investors (I think there was a similar case in Michael Lewis' book). I think he suggests deep OTM puts because they are cheaper (not relatively cheaper than ATM contracts hence the volatility smile), and he argues the tail risk (therefore put payoff) is still greater than assumed by the market. @James proposed selling puts so it naturally makes him the opposite (short) side of the contract for deep OTM puts... $\endgroup$
    – berkorbay
    Sep 16 '14 at 10:51
  • $\begingroup$ I also considered his 'hedging' strategy by longing an 'outer'-of-the-money put (on a comment to Shahar's answer) and warned about the marginal profit and friction can be less appealing against a risk-free portfolio (to be honest, risk free is somewhat close to zero these days). $\endgroup$
    – berkorbay
    Sep 16 '14 at 10:54

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