Indirect Attack: Cash Secured Puts

The markets have been more insane than the crazy frequent flier covered in their own bodily fluids that you ran on three times last night. Something I have been asking myself over the last two month hiatus from posting on this blog, is Are These Markets Investable? Turn to Twitter, financial blogs, and other social media, and you’ll hear a resounding no! Many large scale institution investors have been slowly backing out of the market, turning to cash. Contrary to what most new investors think (myself included), cash is a position. Cash is freedom to buy assets at a severe discount at a later date. It’s hard to admit that investing in the markets deserve a pause. Maybe its the firefighter in me that is having a hard time watching the world burn and not want to do something to improve my families financial condition. It reminds me a lot of being on a campaign fire.

On a large campaign fire, where flame fronts make crews look like ants, would it be wise to attack the fire head on? Hell no! What do we do? We stand back from a safe location, assess the damage, and then work well ahead of the fire front to cut lines in the dirt in an attempt to deprive a monstrous inferno fuel to burn. This is known as an indirect attack of a fire. In the investing world, when used in a conservative manner, I have found cash secured puts to be a similar analogy.

What Are Puts?

A put is a type of options contract. Like any financial instrument, there are buyers and sellers. If you buy a put, you buy the option to sell a stock the price specified on the option strike price. If you own the stock, you are essentially buying an insurance policy for your stock dipping lower. For instance if XYZ stock is trading at $10 a share, and I have 100 shares of the stock that I bought at $8 a share, I could buy the $8 put option to protect myself for a dip in the stock price. Options contracts have an expiration date. Much like an insurance policy, you pay for protection over the timeline of that contract. There is a lot to options contract pricing, but the main price drivers of an options contract revolve around how volatile the stock is (i.e. how much the stock moves up and down in price in a given timeframe), how long the contract is (the longer the time, the more you pay), and how close the contract strike price is to the price the stock is trading at (the closer you are to the current price is, the more you will pay). In the past few weeks, markets have been moving downward violently. In the ensuing panic, insurance policy put options have gotten expensive. Remember, in every market, there are buyers and there are sellers. Any one can be a seller.

Sell Puts?

If you sell a put, you are agreeing to buy 100 shares of a stock at the strike price listed on the options contract. In return, you receive a premium for selling the contract. This is payment for agreeing to buy the shares at the price listed on the options contract. All that is required is to front the cash in order to pay for 100 shares of the strike price listed on the options contract. Say I was the seller of the $8 put. I would need to keep $800 on hand to pay for 100 shares of the stock. Keeping the cash on hand for selling a put is know as a cash secured put. While some brokerage accounts will offer loaned money to pay for the contract (margin accounts), the safest way to sell a put is to use cash. No matter what your brokerage account tries to peddle on you, using margin (or loaned money) is not the way to sell puts in this market, especially if you are just getting into options trading. Back to the example. Say I sell the $8 put and receive $50 worth of options premium. If the stock price dips to $9 by the time the options contract expires, the buyer of the options contract will not want to exercise the contract. It would not make sense to sell stock at $8 a share, when you could sell it on the open market for $9 a share. As the seller of the options contract, you get to keep the $50 premium, for a net return of 6.25% (50/800).

Now, say the stock dips to $7.50 a share. The contract will be exercised, and I will be forced to buy 100 shares of stock for $8 a share. While this seems like an immediate loss of $.50 a share, or $50, because I received a $50 premium for selling the contract, I have in fact broken even. If it dips below $7.50, I am incurring a loss on my trade. Much like wildland firefighters face the risk of their lines being overrun, this can happen if you fail to truly understand your battleground or the fire rapidly changes. In this market, it pays to be conservative if you begin selling puts.

Why Take The Risk?

Selling cash secured puts has some risk, but if you can answer a few questions about your investing strategy, this tactic can be incredibly powerful. If you have your eye on a certain stock, would you want to buy it now or buy it cheaper later? If you are saving your money in a savings account to buy an asset later, what do you think inflation is doing to those funds while you wait? Stock prices fluctuate greatly on a daily basis. When we see market wide declines, even the best stocks get dragged down with the overall market sentiment. We are seeing this play out currently. If you have done your homework, or paid for top notch research, you now see great assets on sale, with more sales to come. Cash secured puts allow you to buy your favorite assets at a discount. The premium on options contracts allows you to get paid to wait for those prices to reach the level you are willing buy those shares at. More often, the premiums you can receive pay higher than interest on a high yield savings account for the same amount of money used. It’s a beautiful thing. Depending on how far away from the price and how long out you set your contract date out to, you can chase the price of a stock down to absurdly low levels before you get assigned to purchase them.

Using options contracts in this regard, is your metaphorical indirect attack on the stock price. In the firefighting world, we trade real estate for time in being able to prep lines to defend against an impending fire. The closer to the fire you are, the less time you’ll have to react and in many cases, the more dangerous your operations, should the fire move against you. On the flip side of the coin, the more conservative you are in your line construction, the more doubtful it is that the fire will even push up to the boarder of your lines. Your efforts could have been better used elsewhere on the fire (think opportunity cost). In running cash secured puts, it’s no different.

You are not attacking the price of the stock head on by buying the stock outright. Instead, you are conservatively thinking where the stock price could fall between today and the option expiration date and trying to never have the stock price cross below your strike price listed on the option. If you pick a strike price too close to the stock price, the stock could blow past your price, leaving you with huge losses. If you set a price too far below the price of the stock, less and less people will be willing to purchase an insurance policy that will most likely not be used. You will see the price of the premium decrease. I like to shoot for half a percent per week on my cash secured put option trades on conservative trades and 1-1.5% for more aggressive trades. For instance, if I sell a put option for a strike price of $10, I would want to receive $5 per week on conservative trades and $10-$15 per week for more aggressive trades. Can you get more return? Absolutely! Just know that with higher return comes higher risk. As max fear settles into the market, and I feel we are closer to the bottom of the market, I may even get a bit more aggressive in my trading. I don’t think we are there yet.

Cash Secured Put Example

A trade idea I have been looking at revolves around scaling into BitCoin Mining companies. These companies use energy to mine the BitCoin network. Without getting too far into the weeds on their mechanics, by keeping a balance of mined BitCoin in their holdings, and only selling enough to cover their expenses, these stocks are essentially a levered play on BTC. If the price of BTC goes up, their assets will explode in value, leading to a higher stock price. After doing some research, I decided I want to scale into the ticker symbol RIOT. As you can see, RIOT is down on the year from an all time high of $46.28 cents to a measly $5.97 a share. If BTC drops further in price, this could be a big loss, BUT, the upside potential compared to the downside potential is very enticing to me. RIOT is one of the more established and larger BitCoin mining operations.

Because RIOT trades in lockstep with BTC, a highly volatile asset, I am making the decision to be more nimble with my trading here. I have decided I want to sell put options on RIOT only 1-2 weeks out and pick strike prices that are outside of the general trading range. Because the stock is so volatile, I can get premiums that both trade outside the trading range (note the low is $5.82 and $4.50 has a less chance of getting assigned) AND return the premiums I am looking for. Looking at the table of available options, I see the June 17th $4.5 Put Strike as enticing for my risk tolerance and return preferences. When navigating an options table, columns to the right side of the strike price is for Put contracts. The bid price is what you would receive for selling the option (ask is what you would use for buying the option).

The $4.5 put (9 days away at the time of this writing) would get me 7 cents per share or $7 per contract (a contract is 100 shares), and I would be required to hold $450 dollars in reserve to buy the shares should the contract be assigned to me. If the contract doesn’t get assigned in those nine days, I keep the $7, for a return on capital of 1.55555% (7/450). I would be happy to own RIOT at $4.50 a share. Say my total account value was $10,000, $450 would only represent 4.5% of my overall portfolio, satisfying my other rules for investments mentioned in other articles of never having more than 10% of any asset devoted to your portfolio. Minimal risk to getting assigned, adequate return, and huge upside potential on this. I see this as a green light to put the trade on.

What to do with your options premium should you not get assigned?

The cash received from your options premium can be deployed a number of ways. You could keep the cash in you receive in your brokerage account to put on more trades. If RIOT goes up further, you can use this to chase the stock price up, or look for other opportunities elsewhere to sell cash secured puts on. If your option expires worthless, You can also redeploy your capital on the same stock for a different dated option. If you should be assigned eventually in one of your contracts, you could in theory apply all your previous premiums towards your cost base on your assigned stock. For example, if I sold puts against RIOT and collected a total of $100 over the course of time, but then was eventually assigned to buy RIOT at $4.50 a share, my theoretical cost base would be $3.50, if I applied the $100 in premium towards it. There is an alternative strategy. In my case, I am using the premium received on each contract to buy one share per week of RIOT. If I never have the stock assigned to me via my option being in the money, I am essentially dollar cost averaging with profits, while chasing the stock from a safe distance. These shares are bought with options profits, which is essentially making your profits work for you even more. This is especially true for if you use this technique with dividend stocks. If you use the premiums to buy a share of a dividend paying stock, you have risk free stocks (risk free because you bought them with profit money, not your own hard earned money) that are paying you to own them. This is a powerful tool to consider in options trading. To take it a step further, once you buy 100 of risk free shares, you can then sell Call options against your existing holdings. This is known as covered call options strategy and will be the subject of a future blog post.

What Are The Limitations With This Strategy?

Much like the tremendous amount of resources required with cutting dirt highways through the backwoods, cash secured puts are incredibly demanding on resources (cash). If you have a small account size, you may have to put up a lot of capital and expose yourself to a lot of risk of being assigned for a small amount of return. Keep your position sizing in mind. If I wanted no more the 10% of any given stock devoted to my portfolio, and my account was $10,000, I could only buy $1,000 of any given stock. Because options contracts control 100 shares, this would equate to stocks price $10 and under. There are other options strategies that you can use to profit on stocks trading at $1000 per share, but cash secured puts would be the wrong tool for the job if you don’t have a large enough account.

In summary, we are likely to see further downside in our stock markets. While many are saying investing in the market is a no go, as firefighters, we can appreciate bending the rules a bit. Much like we cut lines well ahead of a fire to reach full containment, you can invest in the stock market now while cash flowing your reserved cash. It is important to tread with caution. You need to get a good understanding of what stocks you wish to own and what prices you wish to own them at. There are plenty of great resources out there to get you started on strategy and tactics for putting on cash secured puts. My favorite place to get trade ideas, strategy and tactics can be found free at the Reddit Group thetagang. There are plenty of other options education courses free of charge on YouTube as well as free classes for TD Ameritrade members. By setting up an account and downloading their ThinkorSwim platform, you can practice options trading strategies such as the cash secured put using paper money to really hone your technique.

Be safe and trade well,

-TheFirefighterEconomist