Selling Cash-Secured Puts On An Index

The index short put strategy is a form of selling cash-secured puts. It is a bullish strategy with the goal of generating premiums selling put options that expire worthless. Traditionally, at-the-money strikes are sold. As opposed to using stocks and exchange-traded funds as the underlying securities, index options are cash-settled at a profit if the strikes expire in-the-money (with an intrinsic value component). In other words, no securities will be sold or “put” to us but cash will exchange hands.

The options trader using the index short put strategy projects that the underlying index value to be above the put strike price on the expiration date, leaving the strike price out-of-the-money and expiring worthless. 

Profit Potential

Maximum profit is limited to the premiums received for selling the index puts as with all forms of selling cash-secured puts. This is one of the distinguishing features of put-selling compared to writing out-of-the-money covered calls where share appreciation up to the strike can generate a second income stream for that trade.

Formula for calculating maximum profit is:

• Max Profit = Premium Received – Commissions Paid
• Max Profit Achieved When Index Settlement Value is greater than the Index Put Strike Price, leaving the strike out-of-the-money on expiration

 Profit and Loss Graph

Unlimited Risk

P&L graphs for option-selling are misleading in that they make the assumption that no action is taken when value of the underlying security drops dramatically.

Formula for calculating loss

• Maximum Loss is technically unlimited
• Loss Occurs When Index Settlement Value is less than the Index Put Strike Price – Premium received
• Loss = Index Put Strike Price – Index Settlement Value – Premium Received + Commissions Paid

Breakeven Point

Calculated using the following formula:

• Breakeven Point = Index Put Strike Price – Premium Received

Real-life example

The S&P 500 is one of the most commonly used benchmarks for the overall U.S. stock market. The ticker for this index is SPX or $SPX. Let’s set up a real-life trade using published pricing and not negotiating the bid price with the Show or Fill Rule:

• SPX trading at $2120.95 on 4/27/2015
• $2120 (near-the-money) put for 6/19/2015 has a bid price of $40.00

Let’s enter this information into the BCI Put Calculator (get a free copy by clicking on the “Free resources” link on the black bar of these web pages):

Put calculations for SPX

Note the following:

• The amount of cash required to secure the put is (strike – premium x 100) = $208,000, the maximum loss if index drops to zero and no action is taken
• If the strike expires out-of-the-money (unexercised) the profit is 1.92% which annualizes to 13.24%
• The breakeven is $2120.00 – $40.00 = $2080.00

The put-seller believes that SPX will rise moderately over the next 53 days. If that occurs, the strike will end up out-of-the-money on expiration and the option will expire worthless, the best case scenario.

Let’s say SPX dropped to $2000.00 and the put expired in-the-money by $120.00.. Upon assignment of this option, the trader is required to pay a settlement amount of $12,000 ($120.00 x 100  shares) per contract. Taking into account the premium received for selling the option, which is $4000.00, the trader’s net loss comes to $8000.00. This, of course, assumes no management intervention as the index plummeted from $2120.95 to $2000.00.

If SPX remained above $2120.00 by 6/19/2015, the put expires out-of-the-money. The index put option will expire worthless with no intrinsic value. The trader’s net profit is therefore equal to the amount received for selling the index put option which is $4000.00 or 1.92%

Other popular index options include the Dow Jones Industrial Average Index Options (DJX) and Nasdaq-100 Index Options (NDX). Index options are typically cash settled.

Next live appearances

1- St. Louis, Missouri

September 15, 2015

6:30 PM – 9 PM

Link to register

2- All Stars of Option Trading

September 16, 2015

Discussion panel

New York Stock Exchange

4:20 PM – 5:15 PM

Market tone

US stocks slid while European stocks rose this week, and Asian shares were mixed. A positive US monthly employment report was seen as increasing the likelihood that the Federal Reserve would raise interest rates in September. This week’s economic reports:

• The US economy added 215,000 jobs in July, and the May and June stats were revised up by 14,000 for an average of 235,000 per month, up from the first quarter’s average of 195,000
• The unemployment rate remained at 5.3% and labor force participation at 62.6%, a 38-year low
• Full-time jobs rose to 81.7% of total employment, the highest share since November 2008
• Hourly pay rose 0.2% over the month and 2.1% from a year earlier, while the average work week increased 6 minutes to 34.6 hours
• Crude oil futures fell for a sixth straight week, with OPEC maintaining its output and US crude oil inventories remaining high
•  The US trade deficit widened 7.1% to $43.8 billion in June
• US manufacturing activity grew at a slower pace in July, as the Institute for Supply Management’s purchasing managers’ index fell from 53.5 in June to 52.7
• New orders rose from 56.0 to 56.5
• Initial jobless claims edged up 3,000 to 270,000 for the week ending  August 1st, marking the 22^nd consecutive week of initial claims below 300,000
• Continuing claims declined 14,000 to 2.26 million for the week ended July 25th

For the week, the S&P 500 declined by 1.25% for a year-to-date return of 0.91%.

Summary

IBD: Uptrend under pressure

GMI: 3/6- Buy signal since July 30, 2015

BCI: Cautiously bullish using an equal number of in-the-money and out-of-the-money strikes. An interest rate hike is more likely in September after the recent jobs report and this may have a temporary negative influence on the market.

Wishing you the best in investing,

Alan ([email protected])