Trading Cautiously with Cash-Secured Puts

Caution tape Contemplating dipping your toe into the market? If you are one of those traders who has been sitting in cash altogether or is thinking about adding to your existing positions, some options strategies may offer an alternative to buying stock outright. This may be especially true if you are feeling just “moderately bullish.”

Unless you have been hiding under a rock for the past three months, you probably know that volatility in the markets has been elevated. Now granted, that’s a pretty broad, ambiguous statement. What we can gather from that fact is that, on the average, options prices are probably elevated now when compared to February and March.

Looking at the CBOE Market Volatility Index (VIX), which is a measurement of volatility in S&P 500 Index options, we can see that in the February/March time frame, the VIX was trading somewhere between 15-18%. Over the past month or so, the VIX has held a range of 30-47%, which is more than double where is was just a couple months prior. So why do we care?

Well, because options are relatively more expensive now so there are certain options strategies that can take advantage of this situation. Traders who are looking to take a bullish position (potentially with stock) could consider a short, cash-secured put. Elevated volatility levels may allow you to collect more short put premium compared to lower-volatility environments.

Let’s use the hypothetical stock XYZ as an example, which is currently trading at $250 per share. To purchase 100 shares of XYZ stock, it would cost $25,000 (plus commissions), assuming you are not using margin. This risk may be perfectly acceptable to you if you are bullish on XYZ. But what if you are just cautiously optimistic? Enter the cash-secured short put.

What exactly is this strategy? Well, if the long put gives you the right to sell 100 shares of a stock at the strike price on or before expiration, the short put (when you are selling a put to open a new trade) obligates you to buy 100 shares (if assigned) at the strike price on or before expiration. Short puts can also be used as a stock acquisition tool or as an alternative to a covered call. Typically, put sellers who are using the short put to acquire stock are selling puts at-the-money or out-of-the-money as they try to reduce their cost basis (and, in turn, their risk).

If we continue to use XYZ as an example, a trader might sell the July 240 put for $5.10, obligating himself (for as long as he is short the put) to purchase 100 shares of XYZ stock at $240.00. He is also collecting a $5.10 credit to do so. In this example, the risk in the trade is the strike price minus the premium received, or $23,490 for every put contract he sells. Incidentally, this is also the breakeven level in the trade at expiration (equal to $234.90 in the stock).

So how does it work? If XYZ is at or below $ 240 on or before expiration, there is a chance the put seller will be assigned and therefore forced to purchase 100 shares per each sold put. This is where the words “cash-secured” come in. When the trade was established, he set aside the full risk of the trade ($23,490) and is therefore fully prepared if he needs to buy the stock.

If he was executing this trade in a margin account, he may have been required to commit a portion of the full risk of the trade, but to make it “cash-secured” he sets aside the balance of the funds needed.

Remember, the trader’s original intention was to purchase the stock for $250.00 (or $25,000 for 100 shares). In this case, by using a short put, he may be able to ultimately purchase XYZ at a cost of $234.90, if assigned.

But what if XYZ just takes off from here and never goes down to $240? In that case, the most he can make is the $5.10 collected in premium. The short put is limited in reward. This still represents about a 2% return on risk in a month’s time, but he has to be sure he is okay with the limited-reward aspect of this trade. It is very similar to the covered call in risk/reward and I will discuss that later in the week.

So if you are still a bit unsure about the bullish strength of the market and believe a stock will stay above a certain level by a certain expiration date, the short put is another strategy at your disposal.

Photo Credit: Picture Perfect Pose

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