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Introduction

Investors sell put options on stocks for a variety of reasons – as an income generation strategy, to monetize volatility, or simply because they desire to buy a stock (but only at a lower price).

In this article, we discuss if selling put options is a viable long-term investment strategy. To do this, we compiled the historical outcomes of selling puts on the S&P 500 since 2000, across varying holding periods and strike levels. And computed the losses incurred should these put options be exercised upon maturity.

We see a similar strategy being used by many Private Bank clients in the form of investing in Fixed Coupon Notes (FCNs) and Equity Linked Notes (ELNs), which are typically structured to offer yields of 8% to 15% p.a.

You can read more about the different types of equity structured notes in this article.

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Article Summary

1) Expected returns from selling puts on the S&P 500

2) Step 1 of Calculation: Option premium received from selling S&P 500 put options

3) Step 2 of Calculation: Expected maturity payoff if S&P 500 put options are exercised

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The InvestQuest View

Based on our calculations, we estimate that there is a positive expected return for selling S&P 500 put options at current option prices. From our calculations, the range of expected returns is in the low single digit percentages (it varies depending on the put strike and holding period).

The result (of a positive expected return) makes sense to us. This is because selling put options implies that the investor is “long” the market – such investors should thus be compensated with a positive risk premium as a result.

Personally, we do see value in selling puts. Used correctly, it can help an investor to generate income, manage risk and to express a more customized investment view.

However, this strategy is not for everyone and can be risky if used inappropriately.

Diversification is important when selling puts. Ideally, puts should be sold on stocks from different sectors and geographies, and these puts should have varying maturity dates. This can help to reduce the risk of having a large number of puts being exercised at the same time.

Be aware of the overall exposure. As options are leveraged instruments, one should keep track of the total market exposure, assuming all put options are exercised. This can help reduce the chance of margin calls should the market experience a big pull back. It is imperative to set aside sufficient margin buffer, as the negative impact on portfolio margin may be amplified during a crisis, when stock prices decline alongside a spike in equity volatility.

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1) Expected returns from selling puts on the S&P 500

HOW TO CALCULATE THE EXPECTED RETURNS

In computing the expected returns of such a strategy, we need 2 inputs:

1. Option premium received from selling the S&P 500 put option (green box)
2. Expected loss if put option is exercised (orange box)

The expected return from selling puts on the S&P 500 would then be #1 minus #2.

In the interest of time, we detail how we derived #1 and #2 later. Check out Sections 2 and 3 if you’re interested in seeing what level of premiums you can expect to receive from selling an S&P 500 put option and the expected loss if the put option is exercised.

THE RESULTS: EXPECTED RETURNS FROM SELLING AN S&P 500 PUT

Let’s jump to the results of our analysis. From the results table below, looking at the cell shaded in blue, it implies that the expected return for selling a 90% strike S&P 500 put option that matures in 90 days would be +2.3% p.a.

OUR OBSERVATIONS ABOUT SELLING A S&P 500 PUT

We make a few observations from the above table.

1. A sell put strategy on the S&P 500 Index looks profitable over the long-run.
2. At current prices, selling puts that mature in 90 to 180 days yield looks to be more attractive than shorter-dated puts that mature in 60 days. This was unexpected, as we would have thought that the faster time decay for shorter-dated puts would result in higher annualized returns to the put option seller.
3. Selling puts with 95% strikes generated the highest expected annualized returns.

Based on our calculations, we estimate that there is a positive expected return for selling S&P 500 put options, across various tenors and strike levels. This makes sense to us as selling put options implies that the investor is “long” the market and should be compensated with a positive risk premium as a result.

COMMENTS ON THE RISK OF SELLING A S&P 500 PUT

In general, the risk of selling a put option depends much on the “underlying security” of the put option. A 90% strike put option on the S&P 500 is going to be much less risky than a 90% strike put option on a relatively more volatile stock such as Tesla.

So let’s take a closer look at the S&P 500.

First we note that the S&P 500’s average peak-to-trough decline within a calendar year is ~14.3%. The below chart uses data starting from 1980, and shows the S&P 500 returns by calendar year (grey columns in below chart), and the largest intra-year price decline (red dots in below chart).

Using this historical data as a gauge, it would suggest that dips of ~10% would have been good entry levels to buy into the S&P 500 – at least during non-crisis periods.

On the flip side, this also suggests that selling put options at a 90% strike should be worth an investor’s consideration. What this means is that if the market dips less than 10% (and the option is NOT exercised), the investor earns the option premium. And if it dips more than 10% (and the option gets exercised), the investor would be buying into the S&P 500 at a good entry level (and still gets to pocket the option premium too).

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Step 1 of Calculation: Option premium received from selling S&P 500 put options

Let’s look at the option premium.

The below table shows the approximate option premium (as a % of S&P 500’s current price) received from selling a S&P 500 put option currently. For example, if the S&P 500 Index is at $4,200, the cell highlighted in blue implies that you would receive about $42 (1% of $4,200), for selling a 90-day put option with a 90% strike price.

The data shown below is a snapshot in time. That said, we believe this to be quite in-line with the historical average – because current equity volatility (a main determinant of option prices) has normalized back to historical averages.

The option premiums received will fluctuate with changes in market volatility, investor sentiment etc. All else equal, an investor would want to sell puts when the option premium received is higher.

Do note that the above table is NOT the expected return to the investor, as it has not factored in the expected losses if the put option is subsequently exercised (which we compute in the next section).

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Step 2 of Calculation: Expected maturity payoff if S&P 500 put options are exercised

Let’s calculate the expected loss if the put option is exercised. To do this, we need to multiply two inputs.

1. Probability of a put option being exercised at the various tenors and strikes
2. Average loss if the put is exercised – i.e. the price gap between the Index level and option strike (i.e. quantum of loss)

To get the statistics for the above inputs, we ran some back-testing on the S&P 500 Index. We reviewed the outcomes of selling put options at various tenors (60-days, 90-days, 120-days and 180-days), and at various strikes (100%, 95%, 90%, 85%), between Jan-2000 and May-2021.

Step 2A) Probability of put option being exercised

In the below table, we show the probability distribution of S&P 500 returns over various holding periods. For example, the cell highlighted in blue means that there was an 8% chance that the S&P 500 declined by more than 10% over a 90-day holding period.

The probability distribution above would also give us the answer of whether a put option would have been exercised upon maturity, assuming varying strikes of 100%, 95%, 90% and 85%, at varying holding periods.

For example, the cell highlighted in blue above implies an 8% chance that a 90-day put option with 90% strike would have been exercised.

Step 2B. Average loss if the put is exercised

In the below table, we show the average loss, assuming that the put option is exercised.

Using the cell highlighted in blue as an example:

• Earlier we found out that there was an 8% chance that a 90-day put option with 90% strike would have been exercised.
• Assuming that a trade falls within this unlucky 8% of scenarios, the average loss would have been 6%.

Expected losses if S&P 500 put options are exercised

In the below table, we show the maturity payoff if put options are exercised. This is done by multiplying the “probability that the put is exercised” and “average loss if the put option is exercised”, which is what the earlier two tables have depicted.

Using the cell highlighted in blue as an example, it implies a maturity payoff of -0.5% for a 90-day put option with 90% strike price, should the put be exercised on maturity.

In summary, to compute the expected returns of a sell put strategy on the S&P 500, we had used 2 inputs:

1. Option premium received from selling the S&P 500 put option – detailed in Section 2
2. Expected loss if put option is exercised – detailed in section 3

The expected return from selling puts on the S&P 500 would then be #1 minus #2.

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The InvestQuest View:

Based on our calculations, we estimate that there is a positive expected return for selling S&P 500 put options at current option prices. From our calculations, the range of expected returns is in the low single digit percentages (it varies depending on the put strike and holding period).

The result (of a positive expected return) makes sense to us. This is because selling put options implies that the investor is “long” the market – such investors should thus be compensated with a positive risk premium as a result.

Personally, we do see value in selling puts. Used correctly, it can help an investor to generate income, manage risk and to express a more customized investment view.

However, this strategy is not for everyone and can be risky if used inappropriately.

Diversification is important when selling puts. Ideally, puts should be sold on stocks from different sectors and geographies, and these puts should have varying maturity dates. This can help to reduce the risk of having a large number of puts being exercised at the same time.

Be aware of the overall exposure. As options are leveraged instruments, one should keep track of the total market exposure, assuming all put options are exercised. This can help reduce the chance of margin calls should the market experience a big pull back. It is imperative to set aside sufficient margin buffer, as the negative impact on portfolio margin may be amplified during a crisis, when stock prices decline alongside a spike in equity volatility.