One of the practical applications of selling cash-secured puts is to buy shares “at a discount” In my books and DVDs I use out-of-the-money puts in lieu of setting limit orders in order to accomplish this goal. Some of our members have inquired about using deep in-the-money puts (strike well above current market value) instead of out-of-the-money strikes in order to both buy a stock at a discount and capture additional premium as well. Let’s break this down the Blue Collar way to see if this approach should be in our arsenal. I am using Michael Kors Hldgs Ltd. (NYSE: KORS) trading at $44.15 at the time I am writing this article and we will review 5-week returns.
KORS option chain as of 9/14/2015 (puts and calls)
Let’s compare the deep in-the-money $50.00 strike with the out-of-the-money $42.50 and $40.00 strikes (all highlighted in brown) using the BCI Put Calculator:
Put Calculations for KORS
The deep in-the-money $50.00 strike creates an opportunity to purchase KORS at a minuscule discount of 0.34% whereas the out-of-the-money puts generate much more significant discounts of 6.80% and 10.99%. Now one might inquire about the huge unexercised return of 13.64%. In order to generate that return, share value would have to move from $44.15 to above the $50.00 strike, possible but unlikely. If we are that bullish, I would prefer out-of-the-money covered calls highlighted in yellow in the left side of the options chain shown above. Here are the calculations from the multiple tab of the Ellman Calculator:
Including upside potential (price movement from current market value up to the respective strike) the $45.00 and $47.50 strikes offer potential 1-month returns of 5.5% and 9.2%
***For a FREE copy of the Basic Ellman Calculator and many additional free resources, click on the “Free Resources” link on the top black bar of these web pages, enter your email address and you’re in.
Discussion
The best way to buy a stock “at a discount” is to sell out-of-the-money puts. The deeper out-of-the-money we go, the greater the discount but the less likely for the options to be exercised. If unexercised, however, we still generate a nice return from the put premium. If bullish, look to incorporating out-of-the-money call options into our strategy.
Option Liquidity and our Premium Stock report
A few of our new members have inquired about the open interest column in our Weekly Stock reports. First, let’s have a look:
Premium Stock report- Open Interest Column
The column circled in red reads “NTM OI > 100 Cntr.” This stands for near-the-money strikes with open interest of more than 100 contracts. A “Y” means that at least one NTM strike meets the guideline; an “N” means that no NTM currently has more than 100 contracts. The blue arrows (HELE and CATY) point to the latter situation. The question we receive periodically is why do we include stocks like HELE and CATY? There are two reasons we include such securities:
- Option liquidity which is measured after market close on Friday can change during the week and perhaps meet our guideline of > 100 contracts and/or a bid-ask spread of $0.30 or less
- We have a significant number of members who also use these lists for the “stock only” (no options) portion of their portfolios
By including “Y” or “N” in the OI column, it is time efficient to either consider or reject these securities.
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Contest leaders as of Friday’s market close (S&P 500 reading at the end of the year)
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Sample Commentary from Dagmar:
“The weekly chart of the S&P 500 is in an uptrend, the monthly chart is reversing up and resistance is the previous all-time high. Usually, from October to December and into Christmas, the market sees an uptrend”.
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Market tone
US stock indices were flat for the week, reflecting the mixed economic data of the week. The CBOE Volatility Index (VIX) dipped below 17 after reaching 19 on Thursday. This week’s reports:
- US nonfarm payrolls increased by 211,000 in November, and revisions added a total of 35,000 jobs to the September and October stats. With the revision, October’s payrolls grew 298,000
- The unemployment rate was flat at 5.0%
- The U-6 broad measure of unemployment, which counts those in part-time jobs and those who have given up looking for work, moved up to 9.9%
- Average hourly earnings grew 0.2% in November and rose 2.3% year-over-year.
- The Institute for Supply Management’s gauge of US manufacturing activity fell to 48.6 in November from 50.1 in October, contracting for the first time since 2012 and the weakest reading since June 2009
- The ISM index of nonmanufacturing activity fell to 55.9 in November from 59.1 in October
- New orders, employment, backlogs and export orders all dropped although the US service sector has grown each month for nearly six years
- US nonfarm worker productivity increased 2.2% in the third quarter, down from 3.5% in the second quarter
- Employees worked 0.3% fewer hours, while unit labor costs rose 1.8% and real hourly compensation was up 2.4%
- US auto sales topped an 18 million annual rate for a record third straight month in November. At this pace, the industry is set to shatter in 2015 the 17.35 million mark set in 2000. November’s sales were up 1.4% from a year earlier assisted by cheap gasoline and low financing
- The US trade deficit widened 3.4%. Exports fell 1.4% and imports declined 0.6%. The decline in exports stems from weak demand abroad and a strong US dollar. Imports have slumped largely because of lower costs for oil and food
- Initial jobless claims rose 9,000 to 269,000 for the week ending November 28th
- Jobless claims remain near 40-year lows
- Continuing claims rose 6,000 to 2.16 million for the week ending November 21st
For the week, the S&P 500 rose by 0.08% for a year to date return of 1.59%.
Summary
IBD: Uptrend under pressure
GMI: 3/6- Buy signal since market close of October 19, 2015
BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes. I remain fully invested using 50% in-the-money strikes until the Fed makes its position on interest rates known and evaluating the ensuing market reaction. I believe that most institutional investors have factored in a 25 basis point rate hike with moderating guidance for the December Fed meeting.
Wishing you the best in investing,
Alan (alan@thebluecollarinvestor.com)
Alan,
Happy weekend!
Your article is timely since we may have a wonderful set up coming for cash secured put writing with January expiration. I do not know and little care what the Fed will do this month. But I care deeply about how the market reacts and what implications it has for my near term tactics.
I am assuming a range bound market this week in waiting and sold condors around the SPX for Friday. I will hold my powder for the following week. But let’s assume the Fed raises on the 16th and there is indigestion on the 17th and 18th into December expiry. Monday the 21st starts the Christmas week and perhaps the Santa Rally as the market wakes up and realizes the world has not ended.
In that scenario I plan to be a heavy seller of cash secured puts after the Yellen announcement into expiry as put prices rise expecting it to be short lived. January could be a very nice income month courtesy of Janet without buying anything!
For portfolio stocks or new buys on any dip the 17th and 18th I will be inclined to either skip call writing for January or do it as far OTM as is worth the bother to get something after commission and stay out of Santa’s way :).
Best wishes to all for a successful week, – Jay
Good reasoning Jay,
I plan to follow your indications.
Good luck to you too – Roni
Thanks, Roni,
I appreciate your always kind words.
There is also a scenario where Janet raises a quarter point, the market says “Hallelujah, at last!” and throws a party going straight up into the Santa Rally.
So I treated this Fed meeting like an earnings announcement or ex-div date and wrote weekly increments to expire this Friday so I am open for Fed week.
If you have covered calls or cash secured puts for regular Dec expiry it may be worth looking at what closing them would do for you this Friday the 11th or Monday the 14th. Then you can be free to play either break on the 17th and 18th. – Jay
Thank you Jay,
I do have some Dec 18 covered calls, so your advice is very timely, and I will certainly follow your advice. – Roni
Premium Members:
This week’s Weekly Stock Screen and Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 12/04/15.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and the BCI Team
Jay,
I’m curious do you have a premium target with your SPX condors? Or do you let the R2 zones dictate what you get? Either way what is your average initial return if you don’t mind my asking.
Nate
Hey Nate,
I have a target of $1000 intake on each wing of a condor for weekly target of $2000. You can target as much as you like but must understand how that impacts your risk! That income level carries about about a $3000 weekly risk. And I only sell them in my IRA to avoid tax headache. I sell the high side wing on an up day/tick and the low side wing on a down day/tick if possible. Never all on one ticket.
I have read debate about the better instrument: SPX or SPY? I use both. SPX is lower commission because of fewer contracts ($5 minimum strike interval versus .50) but SPY has greater liquidity, tighter bid ask but ten times as many contracts. Returns seem incrementally better after commission for SPY given the tight bid ask and better fills.
Risk profile is similar using eiher. As I must emphasize: if you let one wing bust (the market can not be two places at the same time) you will lose 3x what you were paid for that wing and the full condor will be a 50% loser! So I buy back and roll down or up and usually out to the next week when a wing is in jeopardy. Exit strategies are as important here as they are in our core covered call writing! Thanks for asking. – Jay
Jay,
From where the market is at now would you have your short strikes at 2125 call / 2000 put? Also how far do you usually put your long strike from the short strike?
I like SPX because it trades European style so even if your wing busts out you don’t risk being assigned early giving you time to adjust. Aren’t you much more than a 50% loser if one side busts out because you are down whatever your spread price difference is minus premium received for both sides?
I’m curious where does your $3,000 risk comes from? It seems like you would have to have margin on hold much higher than $3000 to return $2000 weekly.
I would like to play with this strategy and see if it works for me.
Nate,
Thanks again for asking and I ask Alan’s kind pardon to explore this topic with you on his board since it is not exactly covered call/cash secured puts related. But it is options income related. I brought it up so it is my fault!
Let’s look at my open condor this week as illustration. I sold SPX 2120/2125 call spread and SPX 2060/2055 put spread to make my “fairway” as I call it 2120 to 2060. My ball needs to stay between those for max profit at Friday close (keeping the $2.300 premium received spending nothing but commission for the week).
My broker knows the market can not be two places at one time so they only froze on margin hold the greater risk of the two wings. In this case the $3,000 I could lose if the high side busts since I sold more contracts there being bearish. Unfortunately my bearishness is playing out and my low side is in trouble.
But we still have three days to go, are due for a bounce and I have not done an exit strategy yet.
Thank you Nate, you did catch my math error in my typing haste. If one loses $3000 on a wing with only $1000 to offset on the other a busted condor is actually a 100% loss when you try for $2000 and end up losing $2000! I double counted a premium. I try like hell to avoid those with exit strategies.
I typically use the R2 and S2 for the week for strike selection fudged with my bias. Like any other option sale the further you go from price action the less you receive but the safer you are.
There is no risk of “assignment” since there are bought options in the mix. Just a question of nerve as expiry approaches if you have a ball that may go into the rough or is already there!
It is a great options income strategy to dove tail with covered call writing and cash secured puts. Just make sure, as always, you understand it completely and operate within your risk envelope,
SPX closed at 2063.59 so please wish me luck the rest of the week :). – Jay
Jay,
Thanks for your clarification and your detailed example. It helped to see the strategy in action. I am accustomed to looking at a six month chart but a weekly chart makes much more sense in this strategy. Sorry to see that the ball didn’t want to stay in the fairway this week. That is not ideal but I know this isn’t your first rodeo and you will adjust accordingly. Thanks again for sharing your strategy.
-Nate
Nate,
I got fortunate with the bounce above my low side strikes yesterday and closed that wing at a break even while the other will expire worthless so an OK week with a little luck getting out of the bear’s way! – Jay
Congrats, way to snatch up that exit when the opportunity presented itself.
Hi Alan,
I am member of blue collar investor and I do covered calls with the stocks that you provide every week. I have a question. I like to know whether it is good idea to do covered calls or selling puts on SPY instead of stocks? what are the pros or cons? Thanks for your help
Regards,
Ram
Ram,
Here is a link to an article I published on this topic:
https://www.thebluecollarinvestor.com/writing-covered-calls-on-broad-market-exchange-traded-funds/
Alan
I think I saw a reference to covered call writing on stocks kept for buy and hold and dividends?
Erich,
Yes, I’ve written on this topic in my books and in this blog. Here are two links:
https://www.thebluecollarinvestor.com/portfolio-overwriting-selling-covered-calls-on-stocks-you-want-to-keep/
https://www.thebluecollarinvestor.com/using-covered-call-writing-to-increase-the-returns-from-a-buy-and-hold-portfolio-part-ii/
Alan
I am a new member and I love your service. In my studies of your program I understand not trading around earnings ,but how about dividends?
Thank You
William
William,
You can and should still sell options an eligible securities despite dividend dates prior to contract expiration. A few important points:
1- The important date is the ex-dividend date, not the distribution date.
2- For those concerned (not me), the worry relates to early exercise when the call buyer wants to capture the dividend. When this occurs it will almost always be the day prior to the ex-date.
3- To avoid early exercise related to dividends, see pages 260-262 of Volume 2 of The Complete Encyclopedia…for a detailed explanation with examples. This would relate to those who hold shares in a long-term buy-and-hold portfolio and/or want those dividends to keep flowing in.
Alan
Alan, I would like to ask you three (3) questions as to how to properly manage my trades prior to expiration Friday when the value of the stock is declining in value.
I need to qualify my question by informing you I have a full-time job and on most days the only time I can “ACTIVELY” manage my trades is during my lunch hour.
My first question is should I place a GTC order at 20% of my premium when I initially entered the trade or should I place a PRICE ALERT to be notified when the premium reaches the 20% point? My second question is after I calculate the 20% point , should I then place the GTC order or price alert notification using the ASK or the LAST as my point of reference?
Due to my work schedule my thoughts would be to use the PRICE ALERT technique. My reasoning is if I use a GTC order then the option is AUTOMATICALLY closed out at any time of the trading day , I would not be able to manage the trade as quickly as I would need to. I would have a stock declining in value without the opportunity to properly evaluate whether I should IMMEDIATELY ROLL DOWN or not. The question is whether the BCI criteria of the 2% ROO, open interest (100) , and bid/ask spread of 30 cents are met and would ROLLING DOWN be a viable choice. My reasoning being , what if there is no strike to roll down to that meets the BCI criteria. Where if a price alert were utilized I would have the OPPORTUNITY to properly evaluate all 4 exit strategies that are available prior to expiration Friday and take what I consider the best course of action one of which is possibly not to roll down , but leave option in place.
I see a least one serious flaw in my use of price alert notifications. The flaw is that by the end of the trading day or next day when trading begins (in other words, before I have the opportunity to properly evaluate all 4 exit techniques the price of the premium has increased back above the 20% point which would lead to a missed opportunity).
My third questions is does the BCI criteria of ROO of 2% remain the same as the time gets closer to expiration Friday. In other words if three weeks of trading remains would ROO criteria be 1 1/2 % and if 2 weeks 1% ROO .
I know there is no one technique (GTC vs. PRICE ALERT) that could be considered the BEST, but which one would you ADVISE to a lunch time trader and WHY.
Thank you for your advise and insight to my questions.
David
David,
I can relate to your situation. I spent most of my option-selling career while being a full-time dentist. I went something like this: filling-root canal-extraction-buy stock-denture impression-insert crown-sell option….But seriously, my responses:
1- Set up a GTC limit order at 20% of original option sale with an alert if exercised. Change to 10% mid-contract.
2- A BTC limit order will default to the “ask” If you sold the option for $2, place a limit order to close at $0.40 or less. If the short call is closed, you can decide on followup strategy during lunch or that evening.
3- Midway through a contract, I will set my ROO goal to 1-2% as theta eats up time value profit…every penny counts.
Alan
Alan,
I have a question I like to make it clear.My question is: What will happen to the Put Options owner if the company goes to bankrupt? Will it become totally wipe out,too? I really for your answer.
Truly Yours,
HT
HT,
If you own put options on stocks of a company that has just declared or filed for bankruptcy, you are in for a large reward. The delivery and settlement of every stock option is guaranteed by the Options Clearing Corporation. Whoever sold you that right to sell shares of that company at that higher price is obligated to fulfill that obligation, so your profit is guaranteed.
Now, what happens when that company files for bankruptcy and trading in its stocks and options are suspended? When that happens, trading of that company’s stocks and options moves to the Over The Counter (OTC) market or what is known as “Pink Sheet” market where you are able to either sell those put options for a profit or exercise the options and sell the stocks for the same profit. Since it is the company that is going bankrupt and and not the person or institution who sold you those put options, you are guaranteed your profit and delivery.
An example of this are put options on Lehman Brothers which filed for bankruptcy in 2008. After filing for bankruptcy, Lehman Brothers’ shares moved from the exchange to the OTC market where it traded at $0.05 per share. That is when put option holders can choose to exercise the put options by buying the shares at $0.05 and selling it at the strike price for a big profit.
Alan
I like this strategy and I have been using it in my ROTH IRA to accumulate shares of dividend growth stocks. But I use at the money puts or slightly out of the money puts. Many times the stock remained above my strike and I kept the premium and repeated the process twice or sometimes three times before I got assigned to the stock.
Martin,
Congratulations on your success with cash secured puts to enter div growth stocks! I hope you turn around immediately and write OTM covered calls on all of them every month without fail switching to weeklies in the ex-div months to hop scotch that date uncovered. You can easily triple your cash flow from any of the Dividend Aristocrats or Champions on Fish’s lists incorporating options not just relying on dividend. And if called, buy back the next dip and do it again…- Jay
I bought my first discounted position through puts on November expiration at a huge discount on GDX. I didn’t actually want to take position but priced dropped quickly before an exit could be made (3% rule). The price was at about 16.5 and I sold the 14.5 puts for a 2% profit. Weeks later it went below 14.5 and I was assigned. Then it dropped to $13. I didn’t panic. I looked at the chart and there was a base at $13 and I thought it would come up but I also wanted out at the first possible chance so I didn’t sell the calls for Dec. I was waiting for price to come up above $14 and it did and I got out at $4.10 with my cost basis at $4.20. A $10 loss per contract. Three days later I could have been out at above 14.7. Am I upset? No. I did what I felt was right for me at the time and I am happy with the results. After all I was down hundreds of dollars a week earlier. Another strategy could have been to sell calls when priced moved higher. I didn’t because I wanted out before the Fed announcement because I didn’t know how gold would react to rate hike news.
GDX does have high volatility so I knew price could move drastically. About 52 iv when SPX was at about 14 iv.
Here are some take aways:
Selling puts can be very beneficial to your cost basis. Instead of paying 16.5 I only paid 14.2. Now if my intention was to be a long term holder this would have been a super entry instead of just paying the 16.5 at the time.
High IV does equal High risk. Big moves are expected with such IV.
I think some times people forget that they are holding a portfolio. Remember one position losing doesn’t matter if the rest of your portfolio is doing well. I could have sold at the bottom and still had a profitable month.
You can only trade what is in front of you at the current time. We can put the odds in our favor by using good fundamentals and technicals. We can’t see the future so all we can really do is trade the present.
Don’t panic! Think through your decisions before making them. If they make sense act on it. If price broke below $13 I would have made a different decision. Either sell OTM calls or just cut the loss.
The BCI methodology is a beautiful strategy. It works. Once you get comfortable using add your own little tweaks that fit your temperament. Trade intelligently and the profit will come.
Nate,
Thanks for your great post and great read as always!
I am more in Martin’s camp when it comes to cash secured puts: use them to acquire things you would like to own longer term.
GDX is a live snake difficult to hold. Better to just buy a call or debit spread on it a few months out if you like it limiting risk and capital invested.
And I love your coaching to not panic! There are many strategies when it comes to the market. I have never found panic, hope, fear or euphoria to be winners :). – Jay
Alan,
When a stock like LGIH is on the running list for several weeks, then drops off mid-stream, in this case, two weeks before expiration Friday, would you normally buy the call back and sell the stock, rather than waiting until expiration of the call.
Thanks,
Michael
Michael,
If a stock in our current portfolio is “bumped” from our Premium Watch List, we do NOT automatically close the position. It is managed precisely as described in my books/DVDs. Now, if we sell a stock as part of our normal management techniques, a replacement stock is selected from the most recent stock or ETF report.
Alan
I know that this is a really old thread, but I have to say that selling deep ITM puts on TSLA in my 401K retirement account has been the greatest strategy I have ever stumbled upon. If you want to be long a stock more than you have money in your account, you can sell deep ITM puts, use a portion of that extra cash to sell more contracts, creating an extra long position without using margin, getting a decent premium and giving plenty of time for the stock to play out, while capturing all the upside gains on the stock.
I am surprised that this strategy is not used more to be long a stock more than you have cash to support owning that stock directly. Sure, you can buy calls, but not in most 401K accounts. Also, much less risk for selling long dated deep ITM puts. Yeah, the premium is less, but with a really bullish stock like TSLA that can jump 100% in a few months, you need deep ITM position to be able to keep capturing that upside while still being able to roll up as the price continues up and up. With this strategy, I have been able to long the stock an extra 30% or more and with no use of margin and still getting a pretty decent premium to boot.