Excessive Option Profits Revisited

Revisiting index put option selling as mentioned in my 'Caviar Breakfast Everyday' post... The plot above shows the risk profile for 10 October 48 puts on the QQQQs sold naked short. The 48 strike is about 5% out of the money and at the end of the day Friday could be sold for about $0.39. The sale brings in about 5% of the initial margin required so we may make up to about 5% if the options expire out of the money. That is a reasonably good return for one month.

The risk profile shows the profit/loss at various QQQQs prices at expiration (green line) and two weeks prior to expiration (white line). The highlighted area shows the one standard deviation range for the price. As long as the QQQQs only move one standard deviation against us by expiration, we make the maximum profit of $390. If the QQQQs move two standard deviations against us we lose about $1200. If the QQQQs move one standard deviation against us by two weeks prior to expiration, we have an open loss of about $340. The open loss prior to expiration requires us to put up more margin.

We have the potential for substantial profits most of the time. The options in this example will expire value-free about 87% of the time and we will make our maximum profit. The problem is to determine how bad the loses can be. Certainly most of the time all is well, but the price statistics are not normally distributed and disasters will occur more frequently than the normal distribution suggests. However, we are being well compensated for the disasters by the high price of the options.

How do we deal with the occasional disaster? We can just proceed and limit the leverage to avoid being wiped out. We can switch to selling credit spreads to cap our losses in the event of a disaster. We can use market timing to limit out naked selling to periods in which we believe disasters will be less likely. Using credit spreads and/or market timing will limit our profits to some extent.

In summary, I have not reached a conclusion as to whether or not naked index put selling is right for me. I will continue to investigate this approach further. What is your conclusion?