The key is understanding the variables for each trade. On the other hand, you may determine that you are happy with the lower return from selling DIA puts because your risk is more diversified with this approach. Depending on your risk tolerance, you may feel like the additional few percentage points are worthwhile and choose to sell the CVX puts. But the diversification of DIA mutes those risks. CVX’s earnings could be lower than expected, oil prices may decline, or operational issues could cause the stock to trade lower.Īll of those risks affect DIA as well since CVX is one of the components of the Dow. In this example, if you sell puts on CVX, you are opening your account up to several risks. It is important to look at the numbers within the context of risk, rather than simply looking at the raw return data. We could run through the numbers involved with various trade scenarios, but that’s beside the point. Say we are looking at one-month put option contracts for SPDR Dow Jones Industrial Average (NYSE: DIA) compared with a widely-held Dow component like Chevron (NYSE: CVX). To illustrate this point, let’s consider a practical scenario. Stock Or ETF? Deciding Which Approach Is Best for You There are exceptions, but this is true most of the time. Traders who are willing to sell puts on individual stocks are more likely to receive higher income than an index or ETF. So this means that we will be at risk if the ETF or individual stock continues to fall.Īs with most investing strategies, the more volatility (or risk) you are willing to accept, the higher your expected returns. This is because when we sell a put option, we are essentially guaranteeing that we will buy the underlying stock or ETF if it is below the strike price when the put option expires. Of course, a put-selling strategy is not immune to the volatility risks that individual investors face. And that, of course, is responsible for generating income in our portfolio. Higher volatility means more risk to investors. Now think about this pricing dynamic in relation to our put selling strategy for a moment. The higher the level of volatility, the higher the price of the individual option contract. That’s because option prices are heavily influenced by the level of volatility in the underlying stock or ETF. This measure of volatility is important to us as put sellers. (There are problems with this approach, which we outlined here.) It has become industry practice for risk managers to look at volatility (along with other issues such as correlation) to measure the level of risk in individual portfolios. Volatility can be measured in statistical terms.
But, as a general rule, ETFs can help to smooth out the risk of individual company performance for investors.įrom an academic standpoint, this risk is associated with volatility. For instance, the top three holdings might make up 25% of the fund. However, keep in mind that not all ETFs are as diversified as you might think.
One of the primary benefits of investing in an ETF is instant diversification. To determine where you should put your capital to work, let’s consider the benefits and drawbacks of both these approaches. Specifically, some traders struggle to decide whether to sell puts against individual stocks or against broad indexes or ETFs.
But this is only true if you execute the strategy properly.Īs option sellers, one of the most important decisions is what types of securities to sell puts against. One reason is because, as we’ve explained, you can take on less risk than more traditional income strategies. Selling put options can be a tremendous strategy for generating reliable income.
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