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, Joe Springer (445 clicks)
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It was the best of cash-secured puts, it was the worst of cash-secured puts. It was..

On May 25 we assembled The $33,000 American Portfolio as an educational tool for seeking home-run potential with acceptable risk and one of the things we did was write several cash-secured puts. It's time now to check in with those positions and see what we can learn from their performance.

Writing a cash secured put means we sell someone else the right to sell us a stock at an agreed upon price. Our thesis was that the best way to get exposure to two stocks we liked was to write put options. Let's look at the two positions we took May 25 and see how that worked:

1) As I'm writing E-Trade lists a SZYM Sept 22 $12.50 Put bid @ $3.20, we'll write 11 contracts.

11 contracts SZYM Sept 22 $12.50 Put @ $3.20 = $3,520 (10.67% equivalent of portfolio)

2) As I'm writing E-Trade lists an ACI July 21 $8.00 Put bid @ $1.27, we'll write 13 contracts.

13 contracts ACI July 21 $8.00 Put @ $1.27 = $1,651 (5.00% equivalent of portfolio)

First let's look at Solazyme (NASDAQ:SZYM). At the time it traded at $9.90 a share. We could have bought the stock outright. That would be okay but the stock does not pay a dividend. Instead we wrote (sold) 11 put options that expire on September 22 and have a strike price of $12.50. This means that between now and 9/22 someone has the right to sell us 1,100 (each option represents 100 shares) SZYM shares at the price of $12.50. To do this we had to keep $13,750 cash (1,100 X $12.50) on hand to "secure the put." We sold 11 puts for $3.20 each (option prices are listed per share, so even though each put represents 100 shares and hence sells for $320 the price shown is $3.20) for a total of $3,520. Let's do the math. 1,100 shares at $9.90 is $10,890. If we were "put the shares" at $12.50 costing $13,750 we could sell those shares for $10,890, a difference of $2,860. We were paid $3,520 for our puts so the difference is $660, that's our profit if SZYM neither rises nor falls by Sept. 22. In this case $660 is 6.5% of our $10,230 total risk ($13,750 - $3,520) and May 25-Sept 22 is a third of the year, so this trade annualizes to a 19% gain if SZYM trades flat. This is the beauty of writing cash-secured puts. If nothing happens to our stock we get paid for time passing.

Next let's look at Arch Coal Inc (NYSE:ACI). At the time it traded at $7.30 a share. We could have bought the stock outright and it does indeed pay a dividend. We still decided writing put options was the better idea (a quick aside: writing cash-secured puts and writing covered calls are basically equivalent, read Reel Ken to see a slight advantage to the put strategy and see that it compensates for dividends). We wrote 13 put options that expire on July 21 and have a strike price of $8.00. This means that between now and 7/21 someone has the right to sell us 1,300 ACI shares at the price of $8.00. We had to keep $10,400 cash (1,300 X $8.00) on hand to secure the put. We sold 13 puts for $1.27 each for a total of $1,651. So 1,300 shares at $7.30 is $9,490. If we were put the shares at $8.00 costing $10,400 we could sell those shares for $9,490, a difference of $910. We were paid $1,651 for our puts so the difference is $741, our profit if ACI neither rises nor falls by July 21. In this case $741 is 8.5% of $8,749 ($10,400 - $1,651) and May 25-July 21 is a sixth of the year, so this trade annualizes to a 50.8% gain if ACI trades flat. This is the big-eyed lusty allure of writing cash-secured puts.

So we were excited to write these puts, after all, the only thing that has to happen is nothing and we get paid. Nothing! And did nothing happen? Absolutely not! In two and a half short weeks Solazyme had a huge run. Arch, however, had its head cut off and shot out of a cannon. Let's see how this affects our trades.

The Best of Cash-Secured Puts

SZYM closed June 11th with shares last trading at $12.10, a whopping 22.2% run from $9.90 in a very short time. If we were put shares now for $13,750 at $12.50 we could sell them at $12.10 for $13,310. That difference of $440 pales with the $3,520 we got for the puts and leaves us with $3,080 profit, a 30.1% return if SZYM stays at this level until we get put the shares.

The Worst of Cash-Secured Puts

ACI closed June 11th with shares last trading at $5.87, a brutal 19.6% drubbing from $7.30. If we were put shares now for $10,400 we could sell them at $5.87 for $7,631. That difference of $2,679 eclipses the $1,651 we got for the puts and leaves us with a $1,028 loss, an 11.7% loss if ACI stays at this level until we get put the shares.

We Were All Going Directly to Heaven..

In these two examples we've seen that writing cash-secured puts:

  • can profit on a flat stock
  • can augment profits on a rising stock
  • can defer losses on a falling stock

So there are advantages to writing cash-secured puts instead of owning common stock. It is like being paid a premium to own the common stock and could be considered a conservative strategy.

We Were All Going Directly the Other Way

There can be two important disadvantages to writing puts instead of owning common stock. The first is liquidity. When you write a put you open a trade and can gain or lose money. To close your trade you have to buy the same put that you sold, flattening out the trade. In a big stock like Apple (NASDAQ:AAPL) this is no problem, there are lots of buyers and sellers. You could write your put and then immediately buy back the same kind for virtually the same price. But in smaller stocks like SZYM and ACI there are less buyers and sellers and there is a "spread" between the price buyers and sellers are willing to do business. For example the SZYM put had a listed asking price of $3.50 when the bid was $3.20. That's almost a 10% difference. In a more liquid stock there might have been buyers and sellers at $3.35 and we could have gotten that price to start with. If we hold the trade through expiration or get put the shares then liquidity of the options no longer matters, but if we want to close the trade early then liquidity can get you coming and going.

The second disadvantage writing cash-secured puts can have is cutting off upside of a stock. When we wrote the SZYM put at the $12.50 strike price $12.50 plus the premium became the ceiling for this trade. If SZYM gets bought out tomorrow for $20 a share it might just as well have been for $12.50 as far as we are concerned. We picked the $12.50 strike price thinking that if SZYM runs 25% (from $9.90) in 4 months we might sell anyway, so this does not have to be a negative, but it should be on our minds when we pick a strike price.

Conclusion

As our hypothetical portfolio has shown, writing cash-secured puts in lieu of owning common stock can be a great way to invest as long as we are aware of the possible disadvantages liquidity and upside-capping can have.

Source: A Tale Of Two Putties