Cash Secured Puts - Enhance Portfolio Returns.

Summary

Long-term investors who thoroughly analyze the fundamentals of undervalued companies often choose to accumulate shares gradually over time. One effective strategy available to investors for optimal share accumulation is selling cash secured puts. This strategy offers a significant advantage by allowing investors to enhance portfolio returns through the receipt of option premiums while patiently awaiting the stock to reach a desired buying price.

What Is The Cash-Secured Puts Strategy? The cash-backed 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 purchase the stock if the put gets assigned.

When Do You Trade Cash-Secured Puts? This is particularly useful if a trader/investor is optimistic on a stock over the longer term but believes that there could still be some downward movement in the stock price in the short term. This can occur in optimistic, pessimistic, or even volatile markets. In fact, volatility would be advantageous 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 favor. If the stock drops below the strike price by expiry, you will be assigned the shares at the strike price (you will have to purchase the shares at the strike price). If the stock remains above the strike price, you will continue to keep the premiums with no additional obligations.

What Are The Potential Benefits Of This Strategy?
a) Enhance overall investment returns. 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 remains above the strike price on expiry, then you get to keep the premium for no additional obligations.
b) Generate premiums repeatedly. The most appealing aspect of the strategy is if the option expires with the stock price slightly above the strike price, then it gives you an opportunity 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 skyrockets instead of falling to your strike price, you will miss out on potential profits compared to if you had purchased 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) Dependency on the stock's path. There will be scenarios where the stock drops below your strike price before expiry and then rises 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 uncertainty. The purchaser of the option can exercise the option at any point during the duration of the option (equity options are American style). Therefore, it is crucial to have sufficient funds available to accept delivery of the stock at all times during the duration of the option, not just at expiration.

Example: You desire to acquire 100 shares of stock A at a cost of $100. The current trading price of stock A is $110. You can:

1) Place a limit buy order to purchase 100 shares of stock A at $100 and wait for a fill.

2) Sell 1 out-of-the-money (OTM) put option on stock A with a strike price of $100 and a one-month expiration. Each option represents 100 shares (US stocks) or may represent more if you are trading on the HK exchange/other exchanges. While waiting for stock A to drop below $100, you will receive a premium - let's assume it is $500 in this case.

- If stock A closes below $100 on the expiration day, you will be assigned 100 shares of stock A at $100 each. In addition, you would have already earned a $500 premium.
- If stock A does not close below $100 on the expiration day, you will have no obligations and the option will expire worthless. You get to keep the option premium of $500.

Best Practices In Utilizing This Strategy

Typically, the most skilled traders and investors do not invest all their capital at once. They divide their intended exposure in a stock among different price levels and instruments such as stocks and options. Let's assume a trader wants to accumulate 1000 units of a stock at various 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 Takeaways
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.