Using Covered Puts To Trade Options

Timing the market has proven to be very difficult if not altogether impossible. However creating opportunities to artificially accentuate further downward movement in a given stock one is looking to own is possible. If a stock of interest has substantially fallen yet not enough to pull the buy trigger, then one has an option to “buy” the stock at an even lower price at a later date while collecting a premium in the process. This is called a covered or secured put option. Leveraging covered or secured put options in opportunistic scenarios may augment overall portfolio returns while mitigating risk when looking to initiate a future position in an individual stock. Options are a form of derivative trading that traders can utilize in order to initiate a short or long position via the sale or purchase of contracts. In the event of a covered put, this is accomplished by leveraging the cash one currently has by selling a put contract against those funds for a premium. Traders may also initiate a short or long position via the purchase of option contracts to the underlying security. An option is a contract which gives the buyer of the contract the right, but not the obligation, to buy or sell an underlying security at a specified price on or before a specified date. The seller has the obligation to buy or sell the underlying security if the buyer exercises the option. An option that gives the owner the right to buy the security at a specific price is referred to as a call (bullish); an option that gives the right of the owner to sell the security at a specific price is referred to as a put (bearish). I will provide an overview of how a covered put is utilized and executed. Further details focusing on optimizing cash leverage (covered puts) and the ability to sell these types of options in a conservative way to generate cash while initiating positions in one’s portfolio will follow.

A Few Characteristics To Keep In Mind For Covered Call Options Trading

1. Strike Price: Price at which you can buy the stock (buyer of the call option) or the price at which you must sell the stock (seller of the call option).

2. Expiration Date: Date on which the option expires

3. Premium: Price one pays when he/she buys an option and the price one receives when he/she sells an option.

4. Time Premium: The further out the contract expires, the greater the premium one will have to pay in order to secure a given strike price. The greater the volatility, the greater the time premium will be collected.

5. Intrinsic Value: The value of the underlying security on the open market, if the price moves above the strike price prior to expiration the option will increase in lock-step.

The Covered Put Example

If a stock trades at $100 per share on the open market and one sells its put option at a $95 strike price, he has the obligation to purchase the stock for $95 regardless of the stock price between purchase and expiration. If the stock rises to $110, the option owner will not exercise the right to sell the underlying security to the seller of the option since he could sell the security on the open market for a price greater than the $95 strike price. Since the payoff of sold put options increase as the stock price increases, selling put options is considered bullish. In this case, the buyer believes the stock will decrease in the near-term and buys the right to sell the stock below where the buyer believes the stock price will be in the near term. When the price of the underlying stock surpasses the strike price, the option is said to be "in the money" and at this point, the buyer may exercise the option contract. Conversely, if the stock falls to below $95, the buyer will exercise the option, since he can sell the security to the option seller at the agreed price of $95 if the stock decreases in value to say $85 per share, avoiding a decrease of $10 per share from the strike price. If the stock remains above the $95 strike price, the option expires worthless, and the option seller keeps the premium in the form of cash as profit. Since the payoff for sold put options increases as the stock price increases, selling put options is considered bullish. The seller believes the stock will trade sideways or move to the upside over the near term and thus is willing to leverage his cash while collecting premiums. A comprehensive overview is depicted in Figure 1, illustrating the example discussed above (Figure 1).

Figure 1 – Fictional sequence of events and overview of a covered put and its possible outcomes

Option Expires Worthless

As outlined above in Figure 1, three fates of the covered put can come into in play. Remaining consistent with the example of stock X, the owner of stock X sells a covered put at a strike price of $95. Per my hypothetical example above, the owner has not initiated his/her position, however, he is willing to purchase the shares at $5 less than the current price of $100. This would imply a 5% discount on top of the premium yield. If the share price fluctuates but remains above $95 throughout the contract time span, the option will not be exercised. In this case, the seller of the put would not be assigned the shares as the stock is more valuable on the open market and wouldn’t make sense to sell it to the option seller. In this case, the option seller would keep the $1.50 premium per share and now have the cash freed up. This scenario will result in the option seller maintain liquidity and not owning shares of company X and keeping the premium. Effectively this will provide the option seller with a 1.5% yield from its current price in cash. These option contracts are typically weekly, biweekly and monthly. This $1.50 premium is typical for an out-of-money covered monthly call contract. On a monthly basis, this translates into an 18% return in cash assuming the shares are not assigned.

Option Is Assigned

Since the owner of the shares is buying the right to sell the shares to the option seller at a strike price of $95 this decreases the purchase price by 5% from its current price if the option is assigned. Factoring in the premium of $1.50 per share this brings the total option return to 6.5% ($5.00 away from the strike plus $1.50 for the premium) from the current price if assigned. From the original price of $100 and the current price of $90 for the option, the seller will be assigned the shares at 6.5% lower than when the option was sold while the option buyer will mitigate his losses by $3.50 per share ($5.00 decrease from the strike less $1.50 paid for the premium). If the shares of company X appreciate above the strike price, then the option seller retains the premium and no risk in owning the underlying security.

Buy To Close The Option

If the stock of company X increases during the contract time span, not only will the intrinsic value of the option decrease, but the time value will also evaporate. The further away the stock price is from the strike price in the positive direction the lower the option value. If the option decreases from $1.50 to $0.25, the option seller can buy to close the contract for $0.25 and capture the spread of $1.25 while canceling any right the buyer had to sell his/her shares. Now the cash is liberated to the seller as well as the $1.25 spread in net cash.

Conclusion

The covered put option is a conservative way to utilize options to mitigate risk, generate cash via premiums and augment portfolio returns while initiating a position that is attractive at an even lower price than is currently being traded. The basic framework and keys to selling covered puts are outlined above. The next piece will focus on more specific examples and criteria regarding selling covered puts and optimizing cash leverage. This is a powerful way to accentuate portfolio returns if the stock of interest increases in value, trades sideways or trends downward (without crossing the strike price threshold) as the premium will be kept despite any of these outcomes. To offset the risk of being assigned a security that has fallen below the strike price, the option seller is paid a cash premium that is deposited into the option seller’s account and never relinquished. Taken together, the potential owner of an underlying security can leverage his/her cash in a meaningful manner to mitigate risk and augment portfolio returns. In this scenario, this is accomplished via buying the stock at a lower price than currently being traded and/or retaining the premium only without taking on any risk of owning the actual underlying security. This can be performed in a conservative manner as long as the options are sold far below the current price (out-of-the-money). This exercise can be repeated on a monthly basis for small yields that can be very impactful to any portfolio over the long-term while potentially buying a stock of interest at a lower price anyway.

Thanks for reading,
The INO.com Team

Disclosure: The author has no business relationship with any companies mentioned in this article. The author has no business relationship with any companies mentioned in this article. This article is not intended to be a recommendation to buy or sell any stock or ETF mentioned.