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Cash Secured Puts - How To Enhance Portfolio Returns?
Danny Khoo
Sales Trader
Summary: Long term investors who pick attractive companies after studying their fundamentals usually accumulate shares over a period of time. One of the strategies that investors can use to accumulate shares optimally is to sell cash secured puts. The key benefit to this strategy is the opportunity to achieve better portfolio returns from receiving option premiums while waiting for the stock to move to the price you are comfortable buying at.
What Is The Cash-Secured Puts Strategy?
The cash-secured put strategy involves selling a put option at a certain strike price and expiry date for some premium while keeping enough cash on hand to buy the stock if the put gets assigned.
When Do You Trade Cash-Secured Puts?
This is especially useful if a trader/investor is bullish on a stock over the longer term but believes that there could still be some downside to the stock price in the short term. This can happen in bullish, bearish or even volatile markets. In fact, volatility would be good for option premiums.
- Traders typically sell an out of the money (OTM) put option with an expiry date in the future to earn some premium while waiting for the price to move in their favour .
- If stock moves below strike price by expiry, you will be assigned the shares at the strike price (you will have to buy the shares at the strike price).
- If stock stays above the strike price, you will continue to keep the premiums with no additional obligations.
What Are The Potential Benefits Of This Strategy?
a) Boost total returns from investment. If the stock falls below the strike price on expiry, then you get to own the stock at a price you were comfortable buying at plus an option premium on top of it. If the stock stays above the strike price on expiry, then you get to keep the premium for no additional obligations.
b) Churn premiums repeatedly. The most attractive part of the strategy is if the option expires with the stock price marginally above the strike price, then it gives you a chance to sell a put again at the same strike to earn a similar premium for intending to buy the same number of units of the stock as before.
What Are The Potential Risks Of This Strategy?
a) Loss in potential profits. In the event the stock rockets higher instead of falling to your strike price, you will lose the opportunity to potential profits compared to if you had bought the stock at the current trading price. However, if you had intended to buy the stock no higher than the strike price, this will not affect you.
b) Path dependency risk. There will be scenarios where the stock falls below your strike price before expiry and moves back above the strike price by expiry. If you didn’t have the option, you might have bought the stock on the dip. In this case, you will not be assigned shares at the strike price (buying shares at the strike price) since the option is not in the money during expiry and you might miss out on the eventual upside of the stock because of that.
c) Delivery risk. The buyer of the option can exercise the option at any time during the tenure of the option (equity options are American style). So it is important to have adequate cash to take delivery of the stock at all times during the tenure of the option and not just at expiry.
Example:
You wish to purchase 100 shares of stock A at a price of $100. Current trading price of stock A is $110. You can:
1) Place a limit buy order to buy 100 shares of stock A at $100 and wait for a fill.
2) Sell 1 OTM put option on stock A at strike of $100 with an expiry of 1 month. Each option represents 100 shares (US stocks) or might represent more if you are trading in the HK exchange/other exchanges. You will receive some premium – let’s assume it to be $500 in this case - while waiting for Stock A to move below $100.
- If stock A closes below $100 on expiry day, you will be assigned 100 shares of stock A at $100 each. You would have already earned $500 premium on top of it.
- If stock A does not close below $100 on expiry day, you will have no obligations and option would expire worthless. You get to keep the option premium of $500.
Best Practices In Using This Strategy
Typically, the best traders and investors don’t go all in. They split their intended exposure in a stock over different price points and instruments like stocks and options. Let’s assume a trader wants to accumulate 1000 units of a stock at different prices below:
The investor/trader can achieve the exposure above by figuring out the best mix of stock and option. They can:
- Buy 100 units of the stock at current price and sell 1 lot of put option with strike price at the current price.
- Buy 100 units of the stock at current price and sell 1 lot of put option with strike price at 5% below current price.
- Buy 100 units of the stock at current price and sell 1 lot of put option with strike price at 10% below current price.
- Buy 100 units of the stock at current price and sell 1 lot of put option with strike price at 15% below current price.
- Buy 100 units of the stock at current price and sell 1 lot of put option with strike price at 20% below current price.
The Key Takeaway
Some traders might sell the put options at different strikes at one go. Some might choose to sell put options at one strike first and wait for the stock to move lower to sell the next tranche. Both methods have their own merits and demerits - selling put options in tranches as the stock moves lower would yield better premiums. However, if the stock continues to climb higher instead, you might get even lower premiums than before. As an investor, the most critical part of this strategy is to think about the overall exposure you wish to have and make a detailed plan on how you wish to get there. Every investor has different goals and risk appetite but with the cash secured puts strategy, there will be enough possibilities for you to explore.
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