In this paper, we demystify the mechanics of fully collateralized put-writing and illustrate why we believe this approach offers a potentially valuable complement to traditional investment portfolios—especially in the current investment climate.
What Is Put-Writing?
For all its mystique, selling puts is a rather ordinary exercise. In fact, you effectively buy a put every time you pay an insurance premium—what’s more, you likely overpaid for it.
Consider car insurance: You may purchase coverage to try to mitigate out-of-pocket costs for damages if you get into a fender bender; in options parlance, you are attempting to “put” those expenses back to the insurance company in exchange for your monthly premium. Insurers price their policies with the aim of collecting more in premiums than they expect to pay out in claims. (That’s how they make money.) Policyholders tend to be okay with this arrangement to have access to funds with which to make repairs and get back on the road as quickly as possible.
This same concept applies in the equity market: In our view, investors looking to hedge their risk are often willing to overpay for risk mitigation, especially in an uncertain economic climate. Given this inherent demand, we believe long-term investors potentially can earn attractive rates of return by underwriting equity market risk.
Put simply: If investors are willing to pay premiums for risk mitigation, why not sell it to them?
Put-Writing In Practice
Broadly speaking, if you want long exposure to a risk asset, you can either own it (by buying stock) or lend against it (by buying a bond).
Yet we believe there is a third, potentially attractive way to gain long exposure while reducing price volatility: Underwrite someone else’s equity risk.
Instead of spending money or loaning it, investors can sell (“write”) put options on the S&P 500 index and use their capital as collateral (see figure 1).
Figure 1: Put-writing Can Be a Third Way to Gain Long Exposure and Diversified Income
By using a put-writing strategy, investors have the potential to collect and compound two income streams: a) the premiums from selling puts, and b) the interest on collateral invested in short-term Treasuries.
To illustrate, consider two $100 portfolios: one owning the S&P 500 index, the other holding cash and selling $2 puts on it. As shown in figure 2, if the market rises 5%, that $5 of capital appreciation will exceed the $2 of premium income. (In this example, owning beats underwriting.) However, in flat or down markets, those put premiums provide extra return. (Underwriting wins.)
Figure 2: Collecting Put Premiums Can Provide Income/Buffer Losses in Flat/Down Markets
We believe this strategy gets even more attractive after layering in the second income stream: the returns on the collateral sitting in short-dated Treasuries.
Figure 3 provides a nearly four-decade comparison of the CBOE S&P 500 PutWrite index, which is designed to track a fully collateralized put-writing strategy, versus owning the S&P 500 index outright. According to data from 1986 to 2023, underwriting equities beat owning them when the S&P 500 was moderately bullish, flat or down.1 Furthermore, during this time period put-writing strategies have often recovered from market downturns faster than the underlying index.2
Figure 3: Collateralized Put-writing Can Beat Owning Equities in Many Environments
Source: Bloomberg LP. Index data is gross of fees, and the selected time period reflects the indices’ longest common history. The CBOE S&P 500 PutWrite (“PUT”) Index incepted in June 2007, but CBOE makes available historical backtested data through June 30, 1986.
Note: Indices are unmanaged and not available for direct investment. SPX index put options receive 1256 treatment by the IRS, and hence get 60% long-term and 40% short-term capital gains treatment. In up markets, put-writing typically will not participate in the full gain of the underlying index above the premium collected. Past performance is no guarantee of future results.
Yet another benefit of collateralized put-writing, we believe, is that it demands little discretion from asset managers. Unlike selling traditional insurance, investors don’t need a crystal ball to price put premiums. While an auto insurer may have to wait a month to tally its claims and recalibrate policyholders’ premiums, the options market reprices risk on the fly and in real time—no savvy soothsaying required.
A brief note on put-writing’s more popular sibling, called “buy-writing”: This strategy involves owning the underlying equity index and selling long call options against it, thereby seeking to generate income while capping the capital appreciation of the index.
We believe collateralized put-writing can offer a more capital-efficient way to achieve the same—or better—results. Why? Buy- writing involves being long and short the equity index at the same time, whereas put-writing involves being long both the equity index and Treasuries. In our view, buy-writing generates competing exposures, while put-writing (using only options and collateral) offers complementary exposures.
Like buying insurance, we find that selling calls doesn’t tend to make money over time—nor, in our view, is it an optimal way to generate income while managing equity risk. Both of these goals, we argue, can be accomplished more efficiently by blending put- writing with an investor’s existing index exposure (to help preserve the upside of being long the index) and simply reducing that exposure as needed.
An Attractive Liquid Alternative
While we believe that fully collateralized put-writing can be a potentially attractive complement to traditional investment portfolios in many different market environments, we believe it may be an especially effective solution when:
- Market volatility is high (driving demand for puts and increasing premium income)
- Equity market returns are relatively range-bound (mitigating losses on put-writing)
- Interest rates are elevated (boosting current returns on the cash collateral)
Furthermore, we believe that collateralized put-writing can complement many alternative investments, from hedge funds to private equity; for example, alternative strategies often gain their competitive edge through manager discretion and financial leverage. By contrast, fully collateralized put-writing seeks to add value by taking an unlevered, systematic approach.
Conclusion
We believe options are a valuable, if often misunderstood investment tool.
While many investors have realized that buying puts can be a prohibitively expensive way to manage equity risk, we find that too few have taken the next logical step of selling that very same effectively overpriced reassurance—especially in a potentially higher rate, more volatile and range-bound equity market, when taking that step could matter most.
