Options Trading: Writing Cash-Secured Puts

Cash-secured put options are similar to ‘limit buy’ orders in that they potentially allow you to acquire a stock at a later date at a price below the current market value.  The main advantage of writing cash-secured puts instead of using limit buy orders comes from the income (options premium) received from the options contract.  By writing a cash-secured put, you are essentially being paid to wait until your order is filled or expires.  As a bonus, if the contract is exercised and you receive your shares, the options premium received acts like a rebate on your purchase price, lowering your adjusted cost base! (See Note 1)

Prerequisites:
When writing a put option, the strike price of the options contract represents the buy price of the security if the contract is exercised.  To ‘cash-secure’ the put, a cash amount equal to the total buy price of the option (strike price multiplied by 100 shares for each contract) must be ‘set aside’ in your trading account until either the options contract is exercised and you buy the shares, or it expires and you keep the premium.  By setting aside the total purchase price of the options, it ensures that no undue leverage is employed and helps to avoid any unnecessary margin calls.

In addition to having enough cash in your portfolio to cover the buy price of the shares should the put option be exercised, your brokerage account must also be approved for put options trading.  Unfortunately only non-registered investment accounts are currently eligible for writing puts in Canada.

Determining an Appropriate Options Series:
Determining an appropriate options series is largely subjective.  By writing short-term in-the-money cash-secured puts, an investor can be relatively confident of receiving their shares at a slight discount to the current market price sometime in the near future (within one month).  By writing longer duration out-of-the-money puts, the options writer can potentially acquire the stock at a larger discount to the current market price and may also potentially receive a larger options premium.  However, the chance that the options contract may never be exercised also increases.

Rate of Return:
When writing medium to long term cash-secured puts, it is important to look at both the annualized options yield if the contract expires out-of-the-money, and the adjusted cost base (adjusted buy price) if the contract is exercised at expiry.

In order to make writing put options worthwhile, I want to receive at least an 8% annualized options yield net of commissions.  This ensures that even if none of my options are exercised, I generate an acceptable return on my cash position.  Similarly, if the put options are exercised, I want my adjusted buy price to be at a suitable discount to the current price.

Example – Abbott Laboratories (ABT):
To outline the process of selecting an appropriate strike price when writing cash-secured put options, I have replicated part of the February 2011 put option chain for Abbott Laboratories (ABT) as Table 1 below.  In addition to the strike and bid prices, I have added columns representing the annualized put option yield based on the bid price and corresponding strike price and the adjusted cost base of the stock should the option be exercised at expiry.  Note that neither column reflects the impact of trading commissions.

Table 1:  Partial ABT ‘Put’ Option Chain for Feb/12

Option

Strike Price

Bid Price

Annualized
Yield

Adj. Cost Base

ABT_110219P00044000

44.00

0.73

6.6%

43.27

ABT_110219P00045000

45.00

1.00

8.9%

44.00

ABT_110219P00046000

46.00

1.35

11.7%

44.65

ABT_110219P00047000

47.00

1.81

15.4%

45.19

ABT_110219P00048000

48.00

2.39

19.9%

45.61

ABT_110219P00049000

49.00

3.05

24.9%

45.95

Before discussing which strike price seems most suitable, note that one of two things happens at the expiry date:

a.       The option expires out-of-the-money:  You do not buy the shares, but keep the option premium.  The return on the cash securing the put option is equal to the annualized yield.
b.      The option expires in-the-money:  You buy the underlying shares at the strike price.  The options premium is applied against the purchase price which results in the stated adjusted cost base for the shares.

Based on the information in Table 1, writing a put option with a strike price of $45.00 or higher would result in an annualized yield of greater than 8%.  Therefore, to differentiate between the various strike prices, it is important to look at the adjusted cost base of the acquired shares if the option is exercised at expiry.

As ABT has a 52-week low of $44.59 and a current market price of $46.92, it would be nice to both acquire the shares at a discount to the current market price, and to acquire the shares near the 52-week low.  Table 2 presents an overview of the discount to market price that would be realized if the various options were to expire in-the-money. Note that for this to happen, the market price would have to fall below the strike price of the relevant option at expiry which may or may not happen.

Table 2:  Discount to Market Price if Exercised at Expiry

Strike Price

Adj. Cost Base
(if exercised)

Discount to Market Price

44.00

43.27

7.8%

45.00

44.00

6.2%

46.00

44.65

4.8%

47.00

45.19

3.7%

48.00

45.61

2.8%

49.00

45.95

2.1%

Given that ABT is trading near its 52-week low and has strong business fundamentals (full analysis to come), if I were interested in acquiring shares, I would consider writing cash-secured puts with a $47.00 strike price.  If the share price remains below the $47.00 at expiry, I would receive the shares with an adjusted cost base of $45.19 which is 3.7% below the current market price and within 1.3% of the 52-week low.  Alternatively, if the share price rises above $47.00 at expiry, I would have generated an options premium of $181 per contract which is equivalent to an annualized yield on the securing cash of 15.4%.

Summary:
Writing cash-secured puts can be a good way to acquire shares at a discount to current market prices or to generate additional income for your portfolio.  However, as with all options trades, it is important to make sure that you fully understand the potential risk & reward and have the necessary collateral (cash reserve) to cover the position.  Writing ‘naked’ options (without having a covering position or appropriate cash reserve) is a highly speculative activity that can quickly result in significant losses far exceeding any initial investment returns.

Happy Investing,
Nathan @ EngineeringIncome.com

Note 1: Taxation on options transactions can be complex.  Records of all transactions must be maintained and should include the date the contract was initiated, total commissions paid, options premiums received, and the outcome of the options trade on the expiry date (expired vs. exercised).  It is strongly recommended that investors trading options in taxable accounts consult their tax or investment advisor to ensure that their taxable income from investments and adjusted cost base are both reported correctly.  An overview of the current Canadian taxation regime with respect to options trading is available from the TMX Montreal Derivatives Exchange for those who are interested.

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure: As of the publication date, the author had no positions in any securities mentioned in this article.

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