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Context Trumping Content and the “Cash-Secured Put Write”

By From the Trading Pits FOXBusiness

Consider the sturdy Midwestern bank that, for generations, earned a stable income loaning money to credit-worthy companies and families. But decades removed from its origins, the bank grows bold and begins lending a lot of money to a diverse host of business concerns all with prime credit. And, to the delight of the board and applause of its shareholders, the bank continued to earn steady interest and kept boosting its bottom line.

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 One day, one of the companies abruptly defaults on one of the bank loans. And, all of a sudden, within one week, there’s a cascading effect and a large number of these borrowers default and the bank’s vault, once chocked-full of sure profits, simply vanishes!  The decades of what appeared to be a safe, steady stream of earnings on the balance sheet are suddenly transformed into a huge crater.

In this situation, the bank was, in effect, short a put option. 

Like short options, loaning money has a lopsided payoff. There is, perhaps a 99% probability of making a gai, but it’s the 1% that eventually catches up to you. Remember, in options trading, odds and probabilities DO NOT matter. What does matter is the impact to you and your portfolio should you fall prey to that 1%.

Who Should Consider the Cash-Secured Put?

So you want to be an options trader…but should you actually choose to dive in? Here are a few qualities you might want to possess before you do.

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  • Be 100% resolute in your conviction to buy the security in which the put is written.
  • Be potentially willing to give up short-term gains in the stock by selling the put, providing you very limited upside benefit.
  • Be potentially willing to buy a stock that is below current market levels, but that has (consequently) continued to be dramatically lower than the put strike at which it was originally sold.
  • Be a person who perceives the cash-secured put trade as payment for entering a stock limit order.
  • Be a person who fully understands and accepts the potential dangers of selling option premium.
  • Be comfortable taking advantage of observed high levels of implied volatility and/or elevated implied levels of options skew.

Defining ‘Cash-Secured Put’ or ‘Cash-Write’

The investor simultaneously sells a put contract and deposits in a brokerage account the full cash amount for a potential purchase of underlying shares. The point of depositing this cash is to ensure it’s obtainable should the investor be assigned on the short put position and be required to purchase shares at the put’s strike price. The net price paid for the underlying shares on assignment is equivalent to the put’s strike price minus the premium received for selling the put in the first place. For this reason, the strike price selected, less the premium amount, should replicate the investor’s target price for purchasing underlying shares.

Example:  Suppose I like the long-term prospects of Weight Watchers International (WTW) yet, the current price of $27.37 per share is a little rich for my blood – I’d feel much more comfortable owning the stock in the low $20’s.

Setup:

  • Sell 1 November $22 put for 80 cents per share or $80 per hundred shares. From my vantage point, this seems like an appropriate amount of premium as judged by the perceived risk.
  • Deposit $2,120 (cash) with the brokerage house. ($22 x 100 shares = $2,200 - $80 (premium received) = $2,120).

Potential Scenarios:

  • Best Case #1: On November expiration, the stock settles anywhere between $22 and $28.17 ($27.37 + $0.80) in which case you keep the $80 of premium.
  • Best Case #2: On November expiration, Weight Watchers shares settle just below $22 and above $21.20. In this case, you will be assigned the stock (recall your conviction) at an attractive price and will also – depending on where it settles between $21.21 and $22 -- keep part of the original premium sold.
  • Worst Case #1:  On November expiration, the stock catapults to the stratosphere - far above $27.37. You were 100% correct with your conviction however dead-wrong about your investment time frame!  Believe me, the $80.00 earned (put premium collected) will feel hare-brained in comparison of “what could have been” if you would’ve simply bought the stock instead of selling that measly put!
  • Worst Case #2:  On November expiration, Weight Watchers falls victim to some outlier “rare-event” subsequently pushing the stock down the basement steps with no hopes of stopping. Your original sincerity of “feeling more comfortable purchasing the stock in the mid-$20’s,” seems ill-advised and misplaced.  You are stuck buying stock well above the current market price – all with the courtesy of that $80.00 worth of premium and an idea just gone plain bad!

Many investors avoid selling puts because of the large downside risk; a stock can always fall to zero. However, these same investors are usually willing to buy stock and hold it through a lengthy decline, far beyond the point at which it should have been sold in the name of prudent risk management. The key to success with this procedure is to understand its unique drawbacks and to implement the strategy correctly in the appropriate market conditions.

*Larry Shover does not own a stake in Weight Watchers International.

Cash Secure Put and Its Synthetic Equivalency to the Covered Call

 Bear in mind writing puts on equities is the same as writing calls on cash. Just as with a covered call, where one must have the securities to deliver if called, with a cash-write program, one must have the cash to deliver if put. Selection of the strikes and expiration of puts to be written is exactly the same as call writing in reverse. As the covered call gives limited protection against equities going lower, so writing puts against cash only gives limited protection against equities going higher. The conditions suitable for covered call writing are suitable for cash-covered put writing:  High implied volatilities and a market view that the stock will drift either sideways or slightly higher.

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