The 2 Best Options Strategies, According To Academia

by: Jim Fink

As many of my readers know, my favorite option strategy is to sell out-of-the-money put credit spreads. The win rate is very high, because we can make money even if the stock remains stagnant or even falls a modest amount. Furthermore, limiting the margin requirement by selling put spreads instead of naked puts substantially increases the trade's rate of return.

Two academic studies - one from 2006 and a more recent one from 2012- - ack up my opinion regarding the superiority of the put-selling option strategy, concluding that while many option strategies lose money, put selling is one of the few option strategies that outperforms a buy-and-hold stock portfolio. The 2006 study states on pages 17 and 22-23 (emphasis added):

In agreement with previously presented results and prior literature, many option portfolios have risk-adjusted performance worse than the benchmark portfolio. However, some option portfolios exhibit risk-adjusted performance which exceeds that of the benchmark stock-only portfolio. When three-month options are used, written put portfolios for all moneyness levels (OTM, ATM, ITM) generate high returns and exhibit positive abnormal performance.

Table 2 on page 27 of the 2006 study ranks option strategies in descending order of return and selling puts with fixed three-month or six-month expirations is the most profitable strategy. At fixed 12-month or longer expirations, buying call options is the most profitable, which makes sense since long-term call options benefit from unlimited upside and slow time decay.

This study supports my strategy of selling puts with 2- to 5-month expirations and buying LEAP call options with one year or longer expirations. Below is an excerpted reproduction of the study's table 2 for options that have fixed three-month expirations during both 10-year and 22-year holding periods:

Option Strategy

Annualized Return: 10-Year Holding Period

Annualized Return: 22-Year Holding Period

Sell ITM Puts

11.1%

13.4%

Sell ATM Puts

10.5%

12.8%

Sell OTM Puts

9.3%

11.5%

Sell ATM Covered Call

8.5%

9.6%

Sell OTM Covered Call

7.8%

10.5%

Buy ITM Call

7.7%

10.0%

Buy OTM Call

7.1%

10.1%

Buy ITM Put

4.5%

8.1%

Buy OTM Put

0.7%

5.6%

Click to enlarge

I'm not surprised that selling puts is the most profitable options strategy, but I'm a bit surprised that selling in-the-money puts is the best strategy. This is probably because the study does not include the horribly bearish 2008-09 stock market period. If the study were updated today, I bet selling out-of-the-money puts would be the number one options strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.