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The Importance of the 3% Guideline When Selling Out-Of-The-Money Cash-Secured Puts

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On 10/20/2023, a BCI premium member shared with me a cash-secured put series of trades executed with Charles Shwab Corp. (NYSE: SCHW). Over the course of 9 months, SCHW dropped in price from approximately $83.00 to $50.87. This series of trades started by selling out-of-the-money (OTM) cash-secured puts which were exercised. The next 7 months involved writing (OTM) covered calls to help mitigate the severe share price decline. I was asked to analyze the trades and if continuing to write OTM covered calls was a viable solution to this losing scenario.

Overview of the SCHW trades

  • 1/13/2023: STO 2 x 3/17/2023 OTM $80.00 puts with SCHW trading at about $84.00
  • 3/17/2023: SCHW trading at approximately $57.50
  • 2 x $80.00 puts were exercised, and shares purchased at $80.00
  • Over the next 7 months OTM covered calls were sold on SCHW
  • On 10/20/2023, SCHW was trading at $50.87

Price chart summary of the SCHW trades

What is the BCI 3% guideline as it relates to selling OTM cash-secured puts?

If share price drops 3% or more below the OTM put strike, we close the put position and avoid the pain of further price decline. Of course, share price can recover, but do we want to take the chance on a security already under-performing our expectations? I submit, no. In the case of the original SCHW put trade, the threshold to close the put trade was $77.60 (3% below $80.00). This price point is 8.8% below the original price of the security ($84.00) when the put trade was initiated. Time to protect ourselves (aka bail).

A picture is worth 100 wordsComparison chart of SCHW versus the S&P 500

Of course, we are all much smarter looking back, but the graphic shows the type of scenario the BCI 3% guideline protects us from. Will this or any exit strategy benefit us 100% of the time? No, nothing works 100% of the time. However, it will protect us from catastrophic losses.

Discussion

The BCI 3% guideline is an excellent tool in mitigating substantial share price decline when selling OTM cash-secured puts. A plan must be in place prior to entering every trade, as how to take advantage of all exit strategy opportunities, whether it’s to mitigate losses or enhance gains.



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17 Responses to “The Importance of the 3% Guideline When Selling Out-Of-The-Money Cash-Secured Puts”

  1. John A February 24, 2024 8:11 am #

    Dear Alan,

    I hope you help me with a question about “itm covered calls”. I’m a little confused.

    Every “itm covered call” has a capital loss component a a part of the entire trade.

    If the premium received is greater that the capital loss; then the trade has a positive outcome.

    My question has to do with the “Wash Sale Rule”.

    If a trader trades the same underlying security over and over, it looks like the capital loss portion

    of the trade would become non-deductible and there the entire premium would be taxable.

    If this is the case then it seems like “itm covered calls” on the same security would therefore

    become unrealistic and undoable.

    I hope you can point out what I may be missing because I would like to continue selling

    “itm covered calls”.

    Thanks in advance for your help in this important matter.

    Your fan,

    John A

    • Alan Ellman February 24, 2024 11:49 am #

      John,

      Since I am not a tax expert, I prefer not to give direct responses to tax questions, but I can point you in a direction that you should find helpful.

      If your goal is to continually write ITM covered calls on the same underlying security and want to avoid selling shares after contract expiration to only repurchase them on the Monday after expiration, simply roll the option out or out-and-up to an ITM strike. This will result in a miniscule time-value cost-to-close … negligible, as we approach 4 PM ET on expiration Friday.

      By doing so, shares will not be sold and subsequently required to be repurchased.

      As an example, if a $50.00 strike is in place and shares are trading at $55.00, we can roll-out to a later-dated $50.00 strike or out-and-up to a later-dated $52.00 (still ITM) strike.

      Use the Trade Management Calculator (TMC) to confirm that the initial time-value return aligns with your pre-stated initial time-value return goal range.

      Alan

  2. Barry B February 24, 2024 10:04 pm #

    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 02/23/24.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them on The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:

    https://www.youtube.com/user/BlueCollarInvestor

    Reminder: Premium Member’s pricing is locked into your current rate and will never see a rate increase as long as the membership remains active.

    Best,

    Barry and The Blue Collar Investor Team

  3. JP February 25, 2024 2:39 am #

    Alan,

    Hope all is well.

    Do you make use of a stocks 5, 20, 5, 100, 200 day MA’s in setting strike prices for Cash secured puts of C Calls?

    Don’t think I have seen this addressed before.

    Best,

    JP

    • Alan Ellman February 25, 2024 8:53 am #

      JP,

      We use 20-day and 100-day exponential moving averages (EMAs) when screening for eligible stocks for option trading, not for strike selection.

      Strike selection (for calls or puts) is based on several factors which align with our pre-stated strategy goals:

      1. Initial time-value return goal range. In my case it’s 2% – 4% for monthly contracts, calls or puts.

      2. “Moneyness” of the option. ITM calls are best suited for bear and volatile markets or if we have a low personal risk-tolerance and prefer the downside protection of ITM calls generally. Use deep OTM put strikes to avoid option assignment.

      3. Specific strategy approach: If we are using “Portfolio Overwriting”, we should locate a deep OTM call strike using implied volatility (discussed in the video) or Delta to generate an ultra-low-risk deep OTM call strike with a highly favorable probability of success (it’s never 100%!).

      Bottom line: Technical analysis one of the 3 critical aspects of stock screening for eligible underlying security selections, but not for specific strike selection. For the latter, we focus on our strategy goals.

      Alan

  4. Adam February 25, 2024 3:43 am #

    Good morning, Alan:

    After Thursday’s run up in the market, I have some questions.

    Prior to composing this email, I did go through and look on the premium website for answers, which in turn led me to more questions. These are the facts:

    1.Sold Covered Call SMH ETF Strike Price $215 EXP 3/15/24. Current price $209.93
    2.Sold Covered Call XLK ETF Strike Price $210 EXP 3/15/24. Current price $205.77
    3.SMH ETF +$3908.83(3.85%)- option$1336.76(down 201.55%) =+$2572.07
    4.XLK ETF +$5213,00(1.9%) -option$1759.56(down 150.98%) =+$3453.44

    I sold these options on Tuesday. As you can see, they are not in the money.

    My first question is that it is only a few days since I sold these options, do I cut my option losses and take my stock profits or sit on this and see how it plays out over the next 21 days.

    Or would I be better served to roll these out to the next month or two and see if I can make a net credit?

    Your thoughts on this would be greatly appreciated.

    Secondly, when I look at my covered calls vs. my cash secured puts, I seem to be more successful selling cash secured puts than covered calls.

    I continue to make money on the underlying securities but lose money on the covered calls.

    Your thoughts on this dilemma would be greatly appreciated as well.

    Thank you, in advance.

    Sincerely yours,
    Adam

    • Alan Ellman February 25, 2024 9:18 am #

      Adam,

      Let me start with this … your current situation is best case scenario and reason to celebrate. It is definitely not a “dilemma”.

      I do give you a lot of credit recognizing the importance of exit strategies, but there are many times when the best action is no action at all. This may be the case with these trades.

      When we sell OTM calls, we create trades with opportunities for 2 income streams, 1 from option premium and the other from share appreciation from current market value to the OTM call strike.

      In your trades, you captured premiums and share prices are accelerating, but still OTM. No dilemma here!

      Now, if share value accelerates exponentially moving forward, leaving the (now) OTM strikes ITM, we can evaluate using the “mid-contract unwind (MCU)” exit strategy. Check out the MCU chapter in my latest exit strategy book to master this potential exit strategy opportunity (not there yet). You can use our Trade Management Calculator (TMC) for these calculations.

      Bottom line: As of now, there is no dilemma and only reason to be pleased with these trades. 20%/10% guidelines should always be in place in the event trades turn against us. Careful monitoring of these and any other trades should continue, and I commend you for doing so.

      Alan

  5. William February 25, 2024 5:00 pm #

    Alan,

    Thanks for a good article!

    My personal opinion is that CSP is a typically reliable and safe option strategy…but I only employ it if I have a long-term bullish outlook on a stock.

    Do you agree that CSP’s should only be considered if you are willing to own the underlying stock if it is assigned to you?

    Switching to the sale of CALLS (Wheel Strategy) was probably a good idea…but your admonition to cut losses at 3% is so ‘ATM”.

    Thanks for (as usual) your excellent advice and council!

    Sincerely,

    William

    • Alan Ellman February 26, 2024 9:37 am #

      William,

      I do agree that one of the criteria we should consider is if we would want to own the underlying security based on the information we have at hand today.

      That said, most sellers of CSPs, do not want to take possession of the shares and, therefore, must initiate exit strategies to mitigate exercise events.

      The PCP (wheel) strategy is wonderful, if we are willing to accept possession of the shares. I have absolutely no problem with this, but others may.

      The bottom line is that we must first define the strategy we are implementing and that will clarify the approach we take.

      Alan

      • Alan Ellman February 26, 2024 10:16 am #

        Alan,

        Thanks for the answer and sharing your wisdom and experience, Alan. It has been exciting to watch your influence and impact grow in the option trading professional community over the years.

        Finding your web-site has been a blessing!

        Cheers,

        William

  6. Adam February 26, 2024 9:29 am #

    Good morning again, Alan:

    Do you ever consider rolling out an option when it is determined the option has hit its 52-week low?

    Thanks again,
    Adam

  7. Alan Ellman February 27, 2024 5:46 am #

    Adam,

    No, historical option activity should not be the focus of our trades.

    We enter of trades using elite-performing underlying securities based on fundamental, technical and common-sense screening. Next, we select options based on initial time-value return goal ranges, moneyness decisions and personal risk-tolerance.

    For covered call writing, we enter of 20%/10% BTC GTC limit orders, to protect against share price decline.

    Rolling decisions are made as expiration is approaching and strikes are ITM. Factors we consider include:

    1. Does the underlying security meet system requirements for the next expiration cycle?

    2. Does the initial time-value return align with our pre-stated goal?

    3. Is there an earnings report to avoid?

    The answers to these questions will guide us to rolling-out decisions.

    Alan

  8. Alan Ellman February 27, 2024 10:58 am #

    Alan interviewed by the Options Industry Council (OIC) in Las Vegas:

    Mark Benzaquen

    Principal / OCC Investor Education

    Instructor / The Options Industry Council

    CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

  9. Paul February 28, 2024 1:12 am #

    Alan:

    I devote a substantial portion of my Options Portfolio to Cash Secured Puts. Most often I select possible candidates from the BCI Weekly Report list, which I have found to be most helpful & reliable. The BCI team efforts are as a result most appreciated.

    As I have no interest in actually owning any of these stocks, but only in generating premium income, I obviously try to select strikes with a low probability of exercise, preferring to see a probability of less than 25%.

    Toward that objective, I start by looking at the estimated low price at expiration suggested by the Implied Volatility value, & hopefully find a strike that works at or below that value, i.e. still generates an acceptable return.

    However, there are occasions where that value has a premium too low to result in a desirable return. Some recent examples are, for March 15 Contracts, on 2/26/24, MA, COR, AIZ & TM. When this happens, & if I still have an interest in the stock, I usually then go back to see if I can find an alternative (higher) Strike with both a probability within my preference limits & a premium that yields a more acceptable return.

    I would be most interested in any comments or advice you care to offer with respect to such situations or the way I have been dealing with it.

    Regards,
    Paul

    • Alan Ellman February 28, 2024 7:26 am #

      Paul,

      When we are using ultra-low risk approaches to our put-selling trades to avoid exercise, by definition, we are willing to accept lower returns than traditional selling of cash-secured puts.

      In your question, you quantified your risk factor as < 25%. Next, we must identify our initial time-value return goal range. Let's say it's 6% -10% per year. Now that may not suffice for traditional put selling but may be appropriate for an ultra-low risk approach. There's the tradeoff ... lower risk, lower returns. I checked the option chain for MA for the (1-month) 3/28/2024 expiration. Using an IV of 15% (for the $475.00 strike), the BCI Expected Price Movement Calculator shows a low end of the trading range at $455.00. This represents an approximate probability of 84% accuracy. Since you are willing to take a greater % risk (< 25%), we can turn to Delta, which will give us an approximate probability of expiring in-the-money and, thus, subject to exercise. The $460.00 put strike shows a Delta of 22.5, which falls within your acceptable range. At this point, we identified 2 strikes with risk factors of approximately16% and 22.5%. These numbers are not precise, but they are statistically meaningful and will provide a framework guideline as how to craft our trades, given our goals and personal risk-tolerance. The screenshot below, shows that the initial 30-day returns annualized are 5.40% (using IV) and 7.50% (using Delta). Now we have all the information we need to finalize our trade decisions. CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG. Alan

  10. Alan Ellman February 28, 2024 4:42 pm #

    Premium members:

    This week’s 4-page report of top-performing ETFs has been uploaded to your premium site. The Select Sector SPDR section is now crafted to align with our streamlined (CEO) approach to covered call writing. The report also lists Top-performing ETFs with Weekly options, mid-week market tone as well as the implied volatility of all eligible candidates.

    Premium member video link:

    https://youtu.be/EXMO-KwZuJs

    For your convenience, here is the link to login to the premium site:

    https://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    https://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

  11. Barry B February 29, 2024 5:58 pm #

    Premium Members,

    This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 02/23/24-RevA.

    The reason for the update is that the stock “COST” was included in error. “COST” is on the “Banned List” and should not have been included in the report. The reason “COST” is on the “Banned List” is because it reports monthly sales.

    Reminder: Premium Member’s pricing is locked into your current rate and will never see a rate increase as long as the membership remains active.

    Best,

    Barry and The Blue Collar Investor Team

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