Friday, January 11, 2019

Selling Cash Secured Puts for Additional Income

By Nero Nguyen of www.financeoholic.com

There has been a rise in the use of options to complement traditional portfolio strategies. As an investor, one can use options to enhance and amplify portfolio returns.

As a seller of options, one can use the power of having time on your side while reducing the overall risk of investing.

Here is a description of how to use put options to enhance the strategy of dividend investment.

Introduction


Options, when used correctly, can enhance a portfolio's returns with additional income. 

Calls give the buyer the right to buy a stock at a specified price at some point in the future. On the other hand, a put option gives the buyer the right to sell a stock at a specified price at some point in the future. 

On the flip side, a seller of a call option will be obligated to deliver the stock to the buyer if the option gets exercised. The same goes for the seller of a put option.  They will be obligated to buy the stock from the owner of the put option if the option gets exercised. 

So how does one use options to generated additional income?


For someone who's building up a stock portfolio, or for someone who already owns stock in a portfolio, using options can add opportunities to generate income both on the upside and on the downside. 

When entering into a new stock position, instead of buying the stock outright, it may be more beneficial to conditionally get into the trade by selling a cash-secured put

To illustrate, let's use an example scenario:
Scenario: It is 10 December 2018 and you want to add Coca-Cola (KO) to your portfolio. You believe it's a strong, mature company and the risks of investing in KO is low. Warren Buffett owns some 400 million shares and you believe it would be good to own some shares. KO is trading at about $49 per share. 
Selling the Cash-Secured Put

Since KO is trading around $49 per share, generally I will find a strike price one or two strikes below the current price to sell my put. I will also consider the amount of premium available for selling the put. Additionally, I will look for options that expire about a month out, say within 30 to 45 days. This is the optimal point at which options begin to decelerate in premium the quickest.  

Below is the January 2019 options chain for KO:
Source: Nasdaq.com

As you can see from the table above, the $49 strike price has a premium of $1.00 and the $48 strike price has a premium of $0.70. 

The Benefits of Selling Cash-Secured Puts

Here's where you can see the benefits of selling puts instead of buying the stock outright. 

If you buy the stock outright, you'll pay $49 per share immediately. But KO won't be paying a dividend until March 2019, so you'll have to wait about three months to receive the $0.39 dividend. 

On the other hand, if you sell a cash-secured put at the $48 strike price, you'll receive $0.70 in premium immediately. That's $0.31 more than KO's quarterly dividend without having to wait three months!

Moreover, if KO drops below $48 per share by the 18 January 2019 expiration date, you'd be obliged to buy 100 shares of KO at $48 per share. That's $1.00 cheaper than buying the stock outright. Some people compare selling puts to metaphorically setting a stop-limit buy order. 

Now if you buy KO for $49 per share and later it the drops to $48, you'd have an unrealized loss of $1.00 per share. Even after collecting KO's next dividend, you'd still be down $0.61 per share. 

Selling cash-secured puts is a strategy that resides in the mindset of wanting to own the underlying stock. And instead of buying the stock for $49 today, you decide to collect $0.70 and wait for an opportunity to buy it cheaper.

What's the Catch?


There are some catches to this strategy, although these are not terrible in my opinion:
  1. Opportunity Cost — If KO pops to $50 per share instead of dropping to $48 per share, then you'll have an opportunity cost of $1.00 per share. Reduce this by the $0.70 premium and your net opportunity cost is $0.30 per share. Unfortunately, the opportunity cost is unlimited. Theoretically, KO could rise up to $100 per share and you'd still only earn the $0.70 premium from selling the put. 
  2. Large Capital Requirement — Most options trading in America are tied to 100 shares of the underlying stock, so you'll need to have enough capital to purchase 100 shares of KO if you got assigned. Depending on your brokerage and its portfolio margin requirements, you'll need up to $4,800 in capital to sell the put.
  3. Time — I prefer to think that when selling options, time is always on my side. As time passes by,  the option's premium slowly depletes until expiration. But the trade locks up your capital for the duration of the option, usually at least a month.
As with any stock trades, the main risk of selling puts is the downside risk. If KO drops to $0 you'll experience the maximum possible loss, whether you sell the put or buy the stock outright. The only silver lining is that your loss will be a little smaller when selling the put.

Next Steps


If you sell a put and it gets assigned, you're obliged to buy the underlying stock. 

But now that you own the stock, you can turn around and sell covered calls to continue generating income. And while you're holding the stock, you'll collect dividends for even more income! 

As with any other trades, if you're new to the world of options, I strongly recommend practicing in a paper account. Even if you have the concept of cash-secured puts memorized in your brain, you may want to get familiar with the brokerage platform you're using. Knowing where to click to select strikes and how to place a sell-to-open versus a buy-to-close order is important. 

Soon enough, you'll be creating your own "dividend" payments from options! 

This article was written by Nero Nguyen of www.financeoholic.com
The author is passionate about achieving financial independence and early retirement.
He enjoys writing and discussing anything and everything finance related.

6 comments :

  1. If you desperately want to purchase a stock at a certain price or lower, selling puts is a horrible idea because then you are not able to purchase the stock. Happened to me. Cost me a lot. If you do not understand my point, options are not for you.

    ReplyDelete
    Replies
    1. Opportunity cost, I assume.

      I assume you mean the stock price can temporarily drop below your price, then go back up again before options expiration. In this case, the options buyer has the choice to exercise or not. So as the options seller, you could miss out on the opportunity to buy the stock at or below your preferred price.

      If you desperately want to purchase a stock at a certain price or lower, entering a stop-limit buy order is preferable.

      Delete
  2. Thanks for this overview FerdiS, I've never done anything with options as of yet but I have been looking to start with cash covered puts for positions I am interested in buying.

    Your write-up was very easy to understand, but as someone that is completely green in the space of options, do you have any books or resources that you would recommend for continued education on the topic?

    ReplyDelete
    Replies
    1. To be perfectly clear, this article is a guest post by Nero Nguyen. I'm happy to publish informative articles like Nero's about options trading and other investment-related topics. Different perspectives are good, in my view.

      Options trading is a very broad topic. I suggest focusing on books that specialize in *selling* options or, more formally, "writing" options.

      Perhaps the author of this article can suggest a specific book or other resources for learning.

      Delete
    2. I had completely overlooked the notes at the top and bottom about this being authored by someone else; guess I had my blinders on, thanks for clarifying.

      Delete

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