Why does OFI trade put credit spreads?

Why does Jim prefer selling put spreads to simply selling a single put? Doesn’t buying a lower-strike put reduce the amount of net income you receive?

Buying the lower-strike put reduces the net income only slightly, but offers two significant advantages over simply selling a single put “naked” (i.e., without any insurance):

Provides insurance against a large downside move and limits risk of loss to five points per share ($500 per contract, assuming a five-point width on the put spread). In contrast, selling a naked put has downside risk all the way down to a stock price of zero.
Significant reduction in margin requirement (because of the limited risk) which allows portfolio capital to be utilized more efficiently and allows the put spread to generate a much higher potential rate of return than selling a naked put. For example, take a $200 stock with a put strike at $200 trading at $5.00 and a put strike at $195 trading at $3.35, if you sell a five-point 200/195 put spread, it will bring $1.65 per share in income, and the investment risk on the put spread will be $335 ($500 spread width minus $165 initial credit received), whereas investment risk on the naked put is $19,500 ($20,000-$500 received). In retirement accounts where margin is not allowed and naked puts must be 100% cash secured, this difference in the amount of capital tied up in the trade is huge (58 times higher).

In a taxable margin account, by contrast, initial margin on a naked put is about 20% of the underlying stock price, or about $4,000 in this stock example, which is still 12 times larger than the $335 investment risk on the five-point put spread. Furthermore, the margin on the put spread is fixed regardless of a subsequent stock-price decline (i.e., no chance of margin call) whereas the margin requirement on the naked put can increase dramatically if the underlying stock falls in price (i.e., margin call very possible).

The much-lower margin requirement of the put spread also frees up portfolio capital to make other profit-generating trades, which increases portfolio diversification.

Recently a new member asked Jim about this in Stock Talk. Consider Jim’s reply:

“You are correct that selling naked puts has a lower breakeven price than a put spread and therefore has a higher probability of success. This is especially true when the naked put is done at a lower strike price than the short put in the put spread.

“On the other hand, a naked put sold at 125 has a huge margin requirement that will result in a very low single-digit rate of return. I calculate rate of return on naked puts as:

net credit/(strike price – net credit) = 1.10/(125-1.10) = 1.10/123.90 = 0.9%

“Less than a 1% rate of return with unlimited downside from 123.90. Not an attractive trade to me. Anyone can generate a high probability of success by selling deep out-of-the-money naked puts on virtually any stock without doing any valuation work, but the tradeoff is a very low potential rate of return combined with the certainty of rare but huge blowups every now and then that easily wipe out the majority of tiny gains. It’s called picking up pennies in front of a steamroller.“