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My previous article (here) put forth a theoretical strategy based on the tendency of the .PUT index (selling near term ATM puts on the S&P 500) to outperform SPY. The theory consisted of two parts: (1) Going "short" on SPY and (2) Simultaneously selling near term ATM puts on SPY.

First, let's see if we can get a better handle on the "whys and wherefores" of such a strategy.

Most option strategies have an equivalent "twin" option. The two part "combo" of shorting SPY and selling a near term ATM put has a "twin." The "twin" is simple - selling a near term ATM naked call. I covered a similar concept in a previous article (here). Most traders familiar with options probably recognized this immediately. Those that don't should look it over and discover this "twin" relationship. There are some differences in margin, cash outlays and possible assignment work-arounds, but the financial outcomes are almost identical.

As a result, the complexity in the theory can be reduced to one of simply selling ATM naked calls. Looking at it this way takes much less "brain power." It also easily explains why the .PUT index outperforms SPY in flat and down markets, but not in rapidly rising markets

Taking the empirical data to its natural conclusion suggests that we could abandon the whole concept of selling puts and shorting SPY and just sell ATM naked calls on SPY. That begs the question - is selling naked ATM calls on SPY, in and of itself, a hedge play?

We inherently know selling naked calls works in a falling market so we need only look at selling ATM naked calls in a rising market. The last three years represents one of the historically biggest bull runs. What better laboratory could we have than that?

Here's a chart of .PUT vs. SPY for the last three years:

Chart

What we see is that .PUT trailed SPY during this cycle. However, it stayed close enough that it eventually reached parity when the climb slowed down.

Here's a more recent chart, covering the last three months.

Chart

As can be seen, SPY outperformed .PUT when the market rose rapidly, but again, reached parity, when the rise slowed or started to give back some of its gains.

Extrapolating from these two charts concludes that during times of a rapid market climb, selling naked ATM calls will be at a disadvantage. Gains during periods when the rise slows or gives a little back (both of which are inevitable) will offset losses incurred during the rise.

This analysis leads to several important conclusions.

1) Selling ATM naked calls (as scary as it may seem) keeps pace with a rising market. Not all the time, but eventually the market rise will slow down enough or reverse course and the naked calls will recover their losses.

2) Selling naked calls provides gains in a down market.

So, if we have a strategy that doesn't cost much in a rising market and makes money in a falling market we have a hedge. Just because it is inherently simple and somewhat counter-intuitive doesn't change the empirical data.

Now, I'm not suggesting the reader sell naked calls as a complete strategy. What I am suggesting is, selling ATM naked calls can be melded into an overall portfolio position as a "stand-alone hedge." Such a strategy will provide down-side protection while smoothing overall results.

There is one very important part of this strategy that needs to be addressed. The .PUT index used near month ATM options. One could try and improve on this result by going ITM or ATM as they thought conditions warrant. Also, weekly options might provide some further gains when used judiciously.

Either one or both of these "tweaks" would be a mistake. Unless one is skilled in timing the market, just go with near month ATM naked calls.

That said, most of the time SPY will land somewhere between two strikes and a decision must be made to go either slightly ITM or slightly OTM. I will choose OTM, provided it doesn't lose more than 50 cents extrinsic, or ITM, provided the gain is at least 50 cents intrinsic.

Additionally, please keep in mind that this strategy plays out well with SPY because it is a low beta stock. I would never consider using this strategy, as a stand-alone, with a high beta stock.

Conclusion: Many people avoid selling naked calls or sell them OTM trying to pick up a little here and there. Selling ATM naked calls on a consistent and regular basis can be an very effective "stand-alone" hedge. It is self-evident that it works in a falling market. Though one would think such a strategy would be ineffective in a rising market, the data does not bear that out. A rapidly rising market will eventually slow its rate of climb and also experience pullbacks. Monies gained during these times should offset any monies lost during the rapid rise.

In my next article, I will discuss how this concept can be melded into the overall portfolio strategy.

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

Additional disclosure: I buy and sell options on SPY.

Source: Selling Naked Calls In A Portfolio Strategy