Naked puts

[Picasso]

This is a potentially hard question to answer as well as a possible discussion on the topic. 

 

I have noticed something a bit unusual the past several months that I never noticed in the past.  I speak to a lot of retail investors (based on what I do for a living) and I have heard a ridiculous amount of times how they are selling puts, often naked without cash to cover, to create an income stream in the teens.  There are special cringe words I hear such as "easy" "no-brainer" "fun" and worst of all "free money."

 

Now normally I think this is a pretty standard thing to do, but this has been brought up more times than I can count.  Because of low interest rates, this seems to have become a strategy to create income since the market has maintained a pretty solid bid.  It sounds like a pretty sound strategy to sell puts on PG or MCD and create some income while you wait for the order to fill.  However I remember what it is like to sell puts on something which is gapping down way below your stike.  It causes a hell of a lot of panic once those levels bust through because people never thought they'd have to be assigned the stock.

 

Then I started to notice large investment firms offer an option overlay to marginable accounts.  So someone might have $5 million in stocks and they can overlay $2.5 million of collateral to sell calls and puts to create some extra income.  This is becoming a popular strategy.

 

In addition I have started to notice the skew on options pricing to be much more expensive on OTM than ATM.  In fact the index I track is at the highest levels since most major market corrections.

 

So I was wondering if anyone knew a way to track how much naked puts are out there or something similar to track the notional amount of market long exposure at certain prices?  I have had some worries that the market is a bit more leveraged than it would otherwise seem and this could play one factor.  I suspect there is no easy answer to this.

 

I appreciate any input or reasons why I should not worry  ;D

[pocoapoco]

What is the index you track to measure skew ?

[Picasso]

What is the index you track to measure skew ?

 

CBOE Skew Index which bases the data on the S&P.  I attached a chart but it goes out further in time.

[bizaro86]

I'm not going to supply any reasons not to worry, and my understanding of skew is limited at best. However, I would suggest you invert that thought. If you're worried about too many people selling puts and being exposed to a downturn, maybe some of those puts are a +EV buy right now? Maybe slightly out of the money puts on big names, the type of thing people would figure doesn't have much downside risk. Even KO was down ~33% from its 2008 peak to trough...

[Picasso]

I'm not going to supply any reasons not to worry, and my understanding of skew is limited at best. However, I would suggest you invert that thought. If you're worried about too many people selling puts and being exposed to a downturn, maybe some of those puts are a +EV buy right now? Maybe slightly out of the money puts on big names, the type of thing people would figure doesn't have much downside risk. Even KO was down ~33% from its 2008 peak to trough...

 

I was also thinking along the same lines of buying these puts everyone is happy to be selling at extremely low volatiltiy levels.  A bit more speculative than my investment philosophy but I have a sense now would be the time to do it.

 

I have thought of this like the Japanese market.  They have rates near zero but many stocks still trade for very low multiplies.  If low rates and such always implied higher multiples, these stocks should be at 30x earnings no problem given the amount of time this spread has existed.  I do not get the warm and fuzzies thinking that low rates and the end of QE is going to imply high multiples on stocks in the US.  It could, but I think history has shown this is not always the case.

 

In general I notice a lot of this put selling has to do with people convinced corporations with big cash hoards and low multiples are low risk investments.  However that did not prevent Apple from dropping from 700 to 390 even with their giant cash hoard.  Granted Apple is more cyclical than a KO or JNJ, but the investment thought is just as complacent.

[scorpioncapital]

Well let's look at it like this. I've seen stocks with puts that are 30-40% OTM. The yield on collateral retained by the brokerage is 20% for 6-8 months. Furthermore the company is buying back stock in significant amounts. Fed put AND company put floor under the stock price. Care to calculate the odds of an adverse event vs a favorable one?

[pocoapoco]

What's a little odd is that if people were selling OTM puts that would lower skew.  But you are seeing higher skew.  Perhaps people are selling ATM puts

 

[Picasso]

Well let's look at it like this. I've seen stocks with puts that are 30-40% OTM. The yield on collateral retained by the brokerage is 20% for 6-8 months. Furthermore the company is buying back stock in significant amounts. Fed put AND company put floor under the stock price. Care to calculate the odds of an adverse event vs a favorable one?

 

Well I think this is the conventional thinking which is why there might be some mispricing.  The two biggest assumptions are the fed put and company buybacks which have definitely worked the past several years. 

 

But if that is the case then these buyback stocks and a fed put should mean no bear market in these stocks for a long time.  Not sure if that sounds logical although on the surface it can make sense on paper.  Stocks do weird things.

 

You're probably right, the odds of success are low.  If you do have a big move it could make up for the low odds.  I am going to try and run some different scenarios and see what I come up with.

[Picasso]

What's a little odd is that if people were selling OTM puts that would lower skew.  But you are seeing higher skew.  Perhaps people are selling ATM puts

 

I think that is accurate because they are generating high yields, like 15% plus.  So if a stock is at 90, they are selling puts at 85 or 87.5.

 

Someone else is buying up the OTM puts.

[bizaro86]

What's a little odd is that if people were selling OTM puts that would lower skew.  But you are seeing higher skew.  Perhaps people are selling ATM puts

 

If people are getting more aggressive selling puts, it makes intuitive sense to me that they would be moving strikes closer to market prices.