Selling cash-secured puts is a strategy with goals of creating monthly cash flow while retaining capital preservation as a priority. However, many of our astute members are also using this strategy to purchase a stock “at a discount” instead of setting up limit order instructions to the broker. Before highlighting the strategy, let’s review the key definitions.
- Selling cash-secured puts: Giving the right, but not the obligation, to the option buyer to sell their shares to us at the strike price by the expiration date. In return for undertaking this obligation, we are paid the option premium.
- Limit order: An order instruction to our broker and placed by our brokerage to buy or sell a specified number of shares at a specific price or better. Length of time can also be specified. In the case of buying a stock, we are agreeing to buy at the limit price or cheaper.
- Out-of-the-money put strike: The put strike, or price we agree to buy the shares for, is lower than the current market value of the underlying security
I am writing this article on 3/30/15 with 3 weeks remaining on the April option contracts. I have selected Ambarella Inc. (NASDAQ: AMBA), a stock on our Premium Stock List as of that date. The price of the stock at the time was $70.35. We will make the assumption that we would like to own the stock but not at that price…$66 would be a great entry point in this hypothetical. A conventional approach to this scenario would be to place a limit order with our broker to buy at $66 or less. The advantage of this limit order is that we are controlling the price point we would enter the position. If the price point is not reached, no trade is executed and we still do not own the shares. The cash would need to be available if the trade was, in fact, executed.
Alternative approach using cash-secured puts
As an alternative to setting a limit order, we will sell a cash-secured put to accomplish the same goal but with an added perk…we get paid if the trade is not executed! Let’s have a look at the options chain for AMBA prior to market open on 3/30/15:
I have selected the out-of-the-money $68 put which generated a premium of $2.05 (perhaps higher by leveraging the Show or Fill Rule, but I will use the published bid). Let’s enter this information into the BCI Put Calculator:
The following stats are gleaned from these calculations:
- The 3-week unexercised return (if share price remains above $68) is 3.11% which annualizes to 63.03%
- The cash required to secure the put is $6595.00 per contract, similar the cash needed to purchase 100 shares at $66 with a limit order
- If exercised, our cost basis is $65.95, meeting our goal to purchase at $66
If a decision has been made to purchase a particular security at a specific price currently below market value, there is a distinct advantage to selling cash-secured puts over setting limit orders. In the former, we are generating cash flow if the option is not exercised and getting paid while our cash waits to be utilized. If the limit order is not reached, we receive no cash and still do not own the desired security. Should the option expire unexercised, the parameters of that contract can be re-set to another strike price based on current market and corporate information. A possible disadvantage to selling cash-secured puts in lieu of setting limit orders is that shares must be purchased in round lots (100 share increments). If an investor wants to purchase in odd lots, limit orders would be appropriate as “the only game in town”.
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***Soon to come: The BCI team is constructing two more amazing tools to enhance our trading skills. The PCP Calculator incorporates both covered call writing and put-selling into one multi-tiered option-selling strategy and the Trade Planner which allows us to manage our trades prior to trade execution, during the contract month and final results. Both will be available within a few months.
Friday’s disappointing job’s report capped a week of mixed data:
- Employers added just 126,000 non-farm payroll jobs, well below expectations, ending 12 consecutive months of increases > 200,000
- Unemployment remained at 5.5%
- Initial claims for US unemployment benefits dropped 20,000 to a nine-week low of 268,000 for the week ended 28 March.
- US manufacturing purchasing manager’s index rose to 55.7 in March from 55.1 in February, its fastest pace in five months. However, the Institute for Supply Management’s index of national factory activity fell to 51.5 in March, from 52.9 in February, the slowest growth in almost two years
- February factory orders rose by 0.2% after a decline of 0.7% in January
- US construction spending fell 0.1% in February
- US pending home sales rose 3.1% in February, according to the National Association of Realtors
- US consumers spent a seasonally adjusted 0.1% more in February after a 0.2% drop in January
- The US trade deficit dropped by 16.9% to $35.4 billion in February, its lowest level since 2009. A now-settled West Coast port labor dispute interrupted the flow of trade
- Oil prices soared on news of declining weekly US oil production and a weaker US dollar. US crude oil futures were priced below $50 per barrel Thursday
For the week, the S&P 500 fell by 0.9% for a year to date return of (-) 0.3%, including dividends.
IBD: Uptrend under pressure
GMI: 3/6- Buy signal since market close of January 23, 2015
BCI: I’m tweaking my current position down to neutral due to pedestrian earnings of late and a slight bias to negative weekly econ0omic reports. As a result, I am favoring in-the-money strikes 2-to-1. An alternative would be to sell out-of-the-money cash-secured puts. This site remains long-term bullish and expects a resurgence of our economy in the second half of the year.
Wishing you the best in investing,
Alan ([email protected])