Managing Bullish Exposure With Less Capital Risk

Key Concepts

• Naked Put: Selling a put option without owning the underlying asset or having a corresponding short position. This strategy offers direct exposure to upside price movement but carries significant downside risk.
• Put Spread (Defined Risk Put): Selling a put option and simultaneously buying a further out-of-the-money put option. This strategy defines the maximum potential loss and reduces the buying power required compared to a naked put.
• Buying Power: The amount of capital required to open and maintain a trading position.
• Delta: A measure of an option's sensitivity to changes in the price of the underlying asset. A 30 delta put option, for example, is expected to move approximately $0.30 for every $1 move in the underlying.
• Tail Risk: The risk of rare but extreme negative events occurring. In options trading, this often refers to the potential for significant price drops in the underlying asset.
• Put Skew: A market phenomenon where out-of-the-money put options are priced at a premium relative to their theoretical value, often due to demand for downside protection.
• Tasty Bites Account: A term used to describe smaller trading accounts where capital efficiency and risk management are paramount.

Staying Bullish with Less Risk: A Defined Risk Approach

This discussion focuses on strategies for traders who are bullish on an asset but want to mitigate the risk associated with traditional bullish option strategies, particularly for smaller accounts. The primary concern is the high buying power requirement and substantial downside risk of selling naked puts.

The Naked Put: A Common but Risky Choice

• Initial Instinct: When traders are bullish, their first instinct is often to sell a naked put. This is perceived as a simple, high-probability strategy offering direct upside exposure.
• Ease of Understanding: Similar to covered calls, naked puts are considered easy for new traders to understand.
• Drawbacks for Small Accounts:
  • High Buying Power: Naked puts can tie up a significant amount of buying power, making them inaccessible for smaller accounts (e.g., under $25,000).
  • Large Downside Risk: The maximum loss on a naked put can be substantial, potentially going to zero if the underlying asset price drops significantly within the trade's timeframe (typically around 45 days).
• Example Data (Naked Put):
  • SPY (45 days, managed at 21 days, 30 delta put):
    • Average P&L: $127
    • Buying Power: $8,600
  • Apple (45 days, managed at 21 days, 30 delta put):
    • Average P&L: $229
    • Buying Power: $12,500
• Inefficiency: These strategies are deemed not very efficient uses of capital due to the high buying power requirement relative to the potential profit.

The Defined Risk Put Spread: Reducing Risk and Buying Power

The proposed solution to the limitations of naked puts is to implement a defined risk strategy, specifically a short put spread. This involves selling a put and buying a further out-of-the-money put to cap the potential loss.

• Methodology:
  1. Sell a 30 delta naked put.
  2. Buy a 10 delta, 10% out-of-the-money short put to define the risk.
  3. The trades are analyzed over five years of data for ETFs like SPY and individual stocks like Apple.
  4. Trades are initiated with a 45-day expiration and managed at 21 days.
  5. Key metrics computed include win rate, average P&L, average buying power, and maximum loss.
• Benefits of the Put Spread:
  • Reduced Buying Power: Significantly lowers the capital required to enter the trade.
  • Reduced Max Loss: Caps the potential downside risk.
  • Maintained Bullish Exposure: While the average P&L is lower, the directional exposure to the upside remains largely intact.
• Example Data (Put Spread):
  • SPY (45 days, 30 delta put + $10 out-of-the-money 10 delta put spread):
    • Buying Power: Reduced to approximately $3,000 (over 50% reduction from $8,600).
    • Average P&L: Reduced to $42 (over 50% reduction from $127).
    • Win Rate: 74% (slightly lower than the naked put's 78%).
  • Apple (45 days, 30 delta put + $10 out-of-the-money 10 delta put spread):
    • Buying Power: Reduced to $3,700 (from $12,000).
    • Average P&L: Significantly reduced.
    • Win Rate: 70% (from 75%).
• The Trade-off: The primary trade-off for reduced risk and buying power is a lower average profit. As stated, "you make less money because you have less opportunity."

Directional Exposure and Correlation

• Similar Directional Exposure: Despite the defined risk, the put spread maintains very similar directional exposure to the naked put.
• Correlation: The average correlation in P&L between a naked put and a 10% out-of-the-money put spread is approximately 90%. This indicates strong directional similarity.
• Magnitude Difference: It's crucial to remember that correlation only measures directional similarity, not the magnitude of the P&L. The P&L difference can be significant due to the cost of the "wing" (the long put).
• Put Skew Impact: In assets like SPY, which exhibit put skew, out-of-the-money puts are more expensive relative to their price. This premium is paid for protection against tail risk. This makes the 10 delta put more costly compared to the 30 delta put being sold.

Max Loss and Buying Power for Smaller Accounts

• Max Loss Reduction: Put spreads offer smaller maximum losses, which is particularly important for "Tasty Bites" accounts (smaller accounts).
• Magnitude of Swings: A $100 move in a small account has a much larger impact than in a larger account. Triple-digit moves, even to the upside, can indicate trading too large for the account size.
• Volatility in Small Accounts: Smaller accounts tend to exhibit more volatility in their portfolio compared to larger ones, which can be managed more effectively.
• Data on Max Losses (Monthly):
  • SPY: Historically shows maximum monthly losses ranging from $2,000 to $6,000, with some instances up to $14,000 in 2025. These are considered too large for most accounts.
  • Apple: Consistently in the $4,000 range for maximum monthly losses.
• Buying Power for Small Accounts: The reduced buying power of put spreads is a critical advantage for smaller accounts, making previously out-of-reach stocks and strategies accessible.
  • SPY Example: Buying power reduced from $8,600 to around $3,000.
  • Apple Example: Buying power reduced from $12,000 to $3,700.
• Impact of Underlying Price: As the price of the underlying asset (like Apple or SPY) increases, the buying power required for the same probability of success trade also increases.

Applying Downsizing Mechanics to Other Strategies

The principle of defining risk to reduce buying power can be applied to various other option strategies:

• Naked Call to Call Spread: Similar to puts, a naked call can be converted into a defined-risk call spread.
• Strangles: Buying further out-of-the-money options can be used to define the risk of strangles.
• Iron Condors, Iron Flies, Butterflies: These multi-leg strategies inherently involve defining risk, often by buying wings to reduce overall buying power.
• Accessibility: This approach ensures that even high-priced stocks or futures can be traded by smaller accounts by making them accessible through defined-risk option strategies.

Takeaways

• Naked Options vs. Defined Risk: While naked options are often favored for their ease of management, large credits, and high win rates, they are not suitable for all account sizes due to their risk and buying power requirements.
• Replicating Performance: Smaller accounts can replicate the performance of naked options by adding long wings to define risk.
• Choosing the Long Wing: The strike price of the long option (the wing) can be chosen based on:
  • Fixed Strike: As demonstrated with the 10 delta option.
  • Target Delta: A specific delta percentage (e.g., 15-30 delta).
  • Specific Dollar Width: For "Tasty Bites" accounts, a fixed width like $5 wide can be used, adjusting the entire spread up or down to manage risk without increasing the number of contracts.
• Risk Management is Key: Spreading off risk is crucial for managing positions effectively, especially in smaller accounts where large swings can be detrimental. Options provide the flexibility to manage risk and participate in various markets.