Selling Cash-Secured Puts Instead of Placing Limit Orders

04/09/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman, of TheBlueCollarInvestor.com, outlines an alternative options trading strategy to setting a limit order, selling cash-secured puts. By citing a real-life example for support, Alan highlights the benefits as well as the drawbacks of using said strategy.

Selling cash-secured puts is a strategy with goals of creating monthly cash flow while retaining capital preservation as a priority. However, many of our astute members are also using this strategy to purchase a stock at a discount instead of setting up limit order instructions to the broker. Before highlighting the strategy, let’s review the key definitions.

Definitions

  • Selling cash-secured puts: Giving the right, but not the obligation, to the option buyer to sell their shares to us at the strike price by the expiration date. In return for undertaking this obligation, we are paid the option premium.
  • Limit order: An order instruction to our broker and placed by our brokerage to buy or sell a specified number of shares at a specific price or better. Length of time can also be specified. In the case of buying a stock, we are agreeing to buy at the limit price or cheaper.
  • Out-of-the-money put strike: The put strike, or price we agree to buy the shares for, is lower than the current market value of the underlying security.

Real-life Example

I am writing this article on March 30, 2015 with three weeks remaining on the April option contracts. I have selected Ambarella Inc. (AMBA), a stock on our Premium Stock List as of that date. The price of the stock at the time was $70.35. We will make the assumption that we would like to own the stock but not at that price…$66 would be a great entry point in this hypothetical. A conventional approach to this scenario would be to place a limit order with our broker to buy at $66 or less. The advantage of this limit order is that we are controlling the price point we would enter the position. If the price point is not reached, no trade is executed and we still do not own the shares. The cash would need to be available if the trade was, in fact, executed.

Alternative Approach Using Cash-secured Puts

As an alternative to setting a limit order, we will sell a cash-secured put to accomplish the same goal but with an added perk…we get paid if the trade is not executed. Let’s have a look at the options chain for AMBA prior to market open on March 30, 2015:

chart
Click to Enlarge

I have selected the out-of-the-money $68 put which generated a premium of $2.05 (perhaps higher by leveraging the Show or Fill Rule, but I will use the published bid). Let’s enter this information into the BCI Put Calculator:

chart
Click to Enlarge

The Following Stats Are Gleaned from These Calculations:

  • The 3-week unexercised return (if share price remains above $68) is 3.11% which annualizes to 63.03%.
  • The cash required to secure the put is $6595.00 per contract, similar the cash needed to purchase 100 shares at $66 with a limit order.
  • If exercised, our cost basis is $65.95, meeting our goal to purchase at $66.

Discussion

If a decision has been made to purchase a particular security at a specific price currently below market value, there is a distinct advantage to selling cash-secured puts over setting limit orders. In the former, we are generating cash flow if the option is not exercised and getting paid while our cash waits to be utilized. If the limit order is not reached, we receive no cash and still do not own the desired security. Should the option expire unexercised, the parameters of that contract can be re-set to another strike price based on current market and corporate information. A possible disadvantage to selling cash-secured puts in lieu of setting limit orders is that shares must be purchased in round lots (100 share increments). If an investor wants to purchase in odd lots, limit orders would be appropriate as the only game in town.

By Alan Ellman of TheBlueCollarInvestor.com

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