Education & Strategy

December 28, 2016  Wed 8:00 AM CT

Core Options Strategies to Keep It Simple: The Cash-Secured Put

One of the appealing features about options trading is that different options can be combined to create a large variety of risk vs. reward profiles. There are tools that allow investors to put together four or more different options to create some strategies that can be rather complex. While it can be fun to throw together a smorgasbord of calls and puts with different expirations and different strike prices, truly understanding the risks and rewards of very complex strategies can be pretty challenging.

While I concede that it is fun to talk about such complex strategies, I actually find that the simplest options strategies often turn out to be the most rewarding. Just because you can build complex options trading strategies doesn't mean that you necessarily should. In fact, I am a big advocate of keeping to the most basic strategies. There is no need to over-complicate investing. Ultimately the two main goals of any investor really come down to (1) managing risk, and (2) generating returns.

In the vein of "keep it simple," when it comes to options trading there are four basic building blocks: buy calls, sell calls, buy puts, sell puts. In options strategy vernacular, these translate to: stock replacement calls, covered calls, protective puts, and cash-secured puts. Over the next few weeks, we are going to discuss each of these basic trades and why you would implement each strategy. These four basic options positions are the foundation of any options trading - and are each a useful strategy in their own right.

This week we are going to discuss the cash secured put. Do you use good-til-cancelled (GTC) limit orders to bid for stock below the market? Most investors do! With the cash-secured put, you can receive money today (and generate a return on the cash in your account) by taking on the obligation to buy stock that you would be willing to own at the limit price that you would have placed your GTC order.

It may seem a little counter-intuitive, but you can use puts to BUY stock. It works like this: (1) you want to buy a stock; (2) you pick the price today that you want to buy the stock; (3) you SELL a put option with a strike price near your desired purchase price; (4) you have on deposit in your brokerage account an amount of cash equal to the potential obligation; (5) you collect (and keep) the premium today while you wait to see if you buy the stock.

If the stock goes up and you do not end up buying the stock, you still keep the premium, If the stock sits here and you do not end up buying the stock, you still keep the premium. If the stock drops below the strike price and you get assigned, you will end up buying the stock at your desired price and you still keep the premium from selling the put!

The risk of selling cash-secured puts is if the stock were to drop significantly and you are obligated to buy the stock. But this is true of placing GTC orders below the market - if the stock drops significantly you will end up buying the stock as it continues lower. However, with the cash-secured put, your actual purchase price of the stock is lowered by the premium you collected from selling the put.

This particular strategy is an interesting way to generate additional returns in your portfolio by collecting premiums on your willingness to be obligated to buy a stock at below current market prices.


Core Options Strategies to Keep It Simple: The Covered Call

This week we are continuing the "keep it simple" series where we discuss basic options trades and why you would implement each strategy. As a reminder, there are four basic options positions that are the foundation of any options trading: stock replacement calls, covered calls, protective puts, and cash-secured puts. Each of these strategies are a useful strategy in their own right. Last week we discussed cash-secured puts. This week it is the covered call.

So, what is a covered call? Defined simply, a covered call is buying or owning 100 shares of stock and concurrently selling 1 call option against that stock. This is sometimes also referred to as a buy-write since you are buying stock and then writing (or selling) a call. It is named a covered call since the obligation to sell the stock (because you sold a call) is "covered" by your ownership of the stock.

The question remains, why would an investor want to sell a covered call? The answer comes in the form of a question: Do you use good-til-cancelled (GTC) limit orders to sell your stock at a higher target price? Most investors do! With the covered call, you can receive money today (and generate income on your existing portfolio) by taking on the obligation to sell stock that you own at the limit price that you would have placed your GTC order.

It works like this: (1) you own shares of a stock; (2) you pick the price today that you would be willing to sell your stock; (3) you SELL a call option with a strike price near your desired target sell price; (4) you collect (and keep) the premium today while you wait to see if you sell your stock.

Here's a handy little chart that compares the possible outcomes from selling a covered call compared to just owning stock alone:
 

Stock Price...Stock AloneCovered CallWinner
Goes Up BigUnlimited GainsLimited Gains up to Call StrikeStock
Goes Up SmallSmall GainSmall Gain + Premium ReceivedCovered Call
Stays FlatFlatPremium ReceivedCovered Call
Goes DownLossLoss -- Premium ReceivedCovered Call


Notice that in 3 of the 4 outcomes, the covered call comes out the winner. The risk of selling covered call is if the stock were to drop significantly. But this is true of owning stock alone, too. However, with the covered call, some of those downside losses are offset by the premium you get to keep from selling the call.

This strategy is an interesting way to generate additional returns on your portfolio by collecting premiums on your willingness to be obligated to sell your stock at a higher target price of your choosing.


Core Options Strategies to Keep It Simple: Stock Replacement Calls

We are continuing the "keep it simple" series where we discuss basic options trades and why you would implement each strategy. As a reminder, there are four basic options positions that are the foundation of any options trading: stock replacement calls, covered calls, protective puts, and cash-secured puts. Each of these strategies are a useful strategy in their own right. Two weeks ago we discussed cash-secured puts. Last week it was the covered call. This week it is stock replacement calls.

So, what are stock replacement calls? Defined simply, this is buying long calls as a "replacement" for a long stock position. The outlook on this position is to profit from an anticipated increase in a stock's price - very similar economically to owning the stock itself.

The question remains, why would an investor want to buy stock replacement calls? If you like a stock and are planning on buying it, you can buy stock replacement calls instead and use less cash to gain positive exposure to the stock's price.

You can profit if your speculation is correct and the stock price goes up. However, if you are wrong and the stock price drops, your risk is limited only to the premium you paid for the call options.

You can determine the amount of risk you are willing to take by choosing the appropriate delta for your calls. Delta is a term that gets thrown around a lot when discussing options. It can be described three different ways: (1) the expected price change in an option for a $1 move in the stock price; (2) the hedge ratio; or, my personal favorite definition, (3) the percentage of price risk of stock ownership. So, if you buy a 60 delta call, you have 60% of the risk versus owning the stock outright.

Here is a graph that shows the risk reward relationship of stock replacements calls:



Notice that if the stock price goes up, you have unlimited potential reward. And if the price drops, your risk is limited to the premium that you paid for the calls.

This strategy is a great way to maintain positive exposure to a stock price's movement up while also limiting the amount of risk you have in the markets. All while utilizing less cash to do so.


Core Options Strategies to Keep It Simple: Protective Puts

This week we are wrapping up the "keep it simple" series where we discuss basic options trades and why you would implement each strategy. As a reminder, there are four basic options positions that are the foundation of any options trading: stock replacement calls, covered calls, protective puts, and cash-secured puts. Each of these strategies are a useful strategy in their own right. Three weeks ago we discussed cash-secured puts. Two weeks ago it was the covered call. Last week it was stock replacement calls. And for the last installment on this series, we have the protective put.

A protective put is owning 100 shares of stock and concurrently buying 1 put option against that stock. The outlook on this position is to profit from an anticipated INCREASE in a stock's price - but your long stock position is "protected" by the long put since you have the right to sell the stock at the strike price of the put.

The question remains, why would an investor want to buy protective puts? If you like a stock and you plan to continue to own it, but you have some concerns about the markets (or the short term prospects of the stock), you can buy a protective put to hedge your position. Realize that nothing is free in options: you pay a premium to buy a protective put, and over time that premium will decay to zero.

That all said, how much is it worth for you to sleep a little easier at night knowing that your stock investment is protected? Some investors use stop-loss orders and think that they are protected. However, if there is bad news in the markets, or if a company makes a bad announcement outside of normal trading hours, the stock will gap lower never getting a chance to execute the stop-loss at a reasonable price. With a protective put, you know EXACTLY where you can sell your stock if something negative should happen. Most people buy home owner's insurance, or car insurance. Why not portfolio insurance?

This strategy is a great way to maintain positive exposure to a stock price's movement up while also limiting the amount of risk you have in the markets. In fact, the risk/reward profit & loss graph of a protective put is identical to the stock replacement calls graph. The difference between the two strategies is that stock replacement calls utilize less capital, but with protective puts if there is a dividend you still collect the dividend since you actually own the stock.

Hopefully you have found this series of articles useful. Please reference back to them when needed. And, as always, please feel free to reach out to us with your questions. We're here to help you any way we can.

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