Thoughts on Cash Secured Puts, Part 2

Last week in this post I wrote about the strategy of using Cash Secured Puts (CSPs) in Rescue My IRA to augment the five-year track record I have in that account with covered calls.  The post referred to the Options Industry Council (OIC) web page, summarizing the information there into an overview of CSPs:

…the risk profile of a CSP trade, while significant (as with any option strategy), is essentially equal to the risk of a covered call trade.  Both trades are focused on the prospect of owning the underlying security, which has market and equity value, rather than trading on the value of the financial instrument represented by the option.  

 

My plan for this second and final post in this introductory series about CSPs is to document what I’ve learned about these options so far, since I began trading them in June 2016.  So far, I’ve sold these options against eight underlying securities:  MOS, VLO, CMI, IP, SKX, FLR, TGT, and SPY.  For the record, my experience with MOS and VLO have already resulted in a refinement of the strategy:  never sell a CSP on a stock or fund that you don’t care to own!

My approach so far has been slightly contrary to the concept outlined on the OIC page.  Instead of using the CSP to discount the eventual price of owning shares, I’ve sought to avoid assignment and to collect premiums for a net gain, essentially trading the CSP as a security in its own right.  This means combining sell-to-open (STO) and buy-to-close (BTC) trades following the old stock market maxim of buying low and selling high, except in reverse.

Still, I’ve had my VLO and TGT trades result in assignment.  These price of these stocks dropped quickly in the days just before my CSPs expired, leaving my options in-the-money, so the shares were assigned.  Although I was able to quickly close those positions at a gain, it reminded me that I still have to do my due diligence research on these trades, and I have since then.

For future CSP assignments, my plan is to simply convert the trade into a covered call situation, writing new options against the same strike price.  In these cases, the CSP premium can be considered a discount, so being called away at the original strike will actually result in a stock gain in these trades.  The takeaway for me is that this is exactly what the OIC described.

Since August, most of my CSP trades used the exchange traded fund SPY as the underlying security, and I’ve evolved to using weeklies in the process.  The contracts were never assigned.  Here is the September record of the SPY trades:

• Three weekly CSPs at strikes between $212.50 and $216.00
• Net option premiums (includes STO/BTC trades and commissions and fees):  $274.00
• Absolute return against highest strike price:  1.26%
• Annualized return based on 21 days invested:  21.98%

Thus, at least for the month of September, I was able to achieve the investment goal that Rescue My IRA uses as a guideline:  seek an annualized return of 12%.  Some of my colleagues on the Yahoo Just Covered Calls board write about their goal of 24% annualized.  That goal seems feasible to me, although achieving it probably will require more research and experience than I have so far.

My way forward is to continue with these trades and build on my experience of 12 or so trades to date.  I do use the portfolio concept of holding 12 to 16 positions as a way to mitigate the risk of trades going extremely south, and it’s inevitable that I will take some hits, but my sense of it is that by combining the due diligence approach I use with covered calls and limiting my picks to stocks I wouldn’t mind owning otherwise will make that risk manageable.

When I have cash sitting in reserve, that capital's return is negligible.  So these CSPs should lead to an improvement in that situation, and improve the annual results for Rescue My IRA in the process.

Thoughts on Cash Secured Puts, Part 1

After some background reading, and after several years’ worth of posts on the Just Covered Calls Yahoo board, I decided I might try incorporating Cash Secured Puts (CSPs) to set up trades in my Rescue My IRA account.  I started making CSP trades in June this year and have written contracts on eight different stocks.  In keeping with my goals for the blog, I thought I might write up a two-parter on what I have learned so far.

Before starting on this topic, I’ll recap the history of Rescue My IRA, which I started in October 2011 with the goal of generating positive returns in good and bad markets.  The trading strategy I chose used covered calls in trades that were initiated either as buy-write transactions or sold against portfolio holdings.  My objectives were to generate returns from three sources:  option premiums, stock gains, and dividends, and to manage capital risk with careful stock selection and account monitoring.

Except for 2016, which was remarkably precisely a break-even year, the account has had positive returns every year since its inception in 2011, and a simple average of the annual rate is about 6.50%.

At the suggestion of one of the members of the Yahoo board, I put together a trading plan to guide trading in this account.  I seek to have between 12 and 16 positions in play at any given time, a portfolio approach that means that I am likely to have some big winners and big losers, but the majority of my trades are likely to generate average returns.  Although each trade is set up to achieve an annualized return of 12 percent, the accounts growth reflects only six to seven percent annualized.

As far as stock picking goes, I tried to simplify the rules into a critical three or four elements:  must be a part of the S&P 500 Index, should be rated 4- or 5-stars by S&P, should pay a dividend at an annual rate of from three to six percent, and generally should be a mid-cap or larger.  There is a combination of liquidity in these rules, meaning I don’t get stuck in trades while trying to execute strategic moves, and the dividend yield rule of thumb combined with the 4-star rating tends to mean I’m picking stocks with more upside opportunity than downside risk.

Because I typically have anywhere from 10 to 30 percent of the account value sitting in cash reserves, and the interest paid on those balances is negligible, I began looking for a strategy I could incorporate to generate additional returns.  Then I learned that my fellow investors regard CSPs as substantially the same as covered calls, and Scottrade began allowing them in IRAs.  A severe price reduction in the underlying security could still create significant risks with any individual holding, but it seems to me that the liquidity aspect of these trades reduces the overall risk of any given contract.

Before I get into what I’ve actually learned from CSP trading already, I thought I would take a minute to cobble together an overview of CSPs, summarized from the Options Industry Council web page:

That web site notes that the risk profile of a CSP trade, while significant (as with any option strategy), is essentially equal to the risk of a covered call trade.  Both trades are focused on the prospect of owning the underlying security, which has market and equity value, rather than trading on the value of the financial instrument represented by the option.    

Rescue My IRA: September 2016 Results

Continuing with the recent trend of starting these monthly Rescue My IRA blog posts with a comparison of some benchmarks to the performance of my account, the covered call approach is holding its own for 2016 year-to-date through September 30.  The account has achieved 6.39% for the year so far, while the S&P 500 index is at 6.08%, and the SPY ETF is at 6.10% - that’s the first time the account has been slightly above the other benchmarks.

Some Cascade hops cones from the 2016 harvest.

On a side note, my home brewing hobby has now turned into a business.  Last year, I started a farming venture to grow hops, which I used in my hobby brews but have also sold to a few Virginia breweries.  This year I pulled the trigger on starting a Nano brewery in the Shenandoah Valley with a five-barrel brew house; all of the financing is in place, the equipment is being fabricated, the mechanical, electrical, plumbing, and construction contracts are in place, and we have submitted for licenses – we hope to open in March! 

I’ve added the second benchmark here, SPY ETF, at the suggestion of one of my colleagues on the Yahoo Just Covered Calls board.  While the ETF is one of my frequent covered call trades, and I have often written Cash Secured Puts (CSPs) against it since early this year, the hypothesis is that it may be a better benchmark than the S&P 500 tracker, since dividends are incorporated, and they are a key part of the strategy for Rescue My IRA.

It was a busy month for the account, with trading activities balanced between option premiums and stock gains.  The highlight was dividends, with eight positions hitting their ex-dividend dates and yielding almost $560 – that amount comprises the cash yield on the account. 

During the month I unwound two positions with the goal of settling back into the routine of having from 12 to 16 trades in progress (the month ended with 15 trades in place).  The cash balance is averaging about 20 percent, but I am using that as a way to write CSPs with about 10 percent of the account value.  To date, most of these trades are on the SPY ETF, as noted above; I think this may be my way forward on   

To keep moving forward in business and in life, we have to keep learning.  That’s where I’m coming down on the CSP question – it is adding value to Rescue My IRA.  I’ll put together a blog post about the approach I’m using later this month.

Here is the benchmark data for the account during September:     

Account Status:

·        Total Account Value, 9/30/2016:  $178,312.12, up from the August close of $177,642.51

·        Total Cash Reserve, 9/30/2016:  $40,066.12, or about 22%

·        Core Stock Positions (as of 9/30/2016):  AAPL (100 shares), DIS (100 shares), DOW (200 shares), FB (100 shares), GM (200 shares), IP (200 shares), MDLZ (200 shares), MET (200 shares), NUE (200 shares), PPL (200 shares), QCOM (100 shares), SPY (100 shares), T (200 shares), TROW (100 shares), XRX (500 shares)

·        Cash Secured Put (CSP) positions (as of 9/30/2016):  None

Performance Metrics:

·        Option Premiums Collected (net, month of Sep):  -$1,306.00 (-0.78%)

·        Capital Gains Collected (net, month of Sep):  $1,286.08 (0.77%)

·        Dividends Collected (recognized on the ex-date): $556.75 (0.33%)

·        Estimated Interest on Cash Reserve: $0.24

·        Total, Absolute Return:  $537.07 (0.32 % absolute return, estimated annualized return 3.85%) 

·        S&P 500 Index 2016 year to date performance as of 9/30/2016: 6.08%

·        SPY ETF year to date performance as of 9/30/2016:  6.10% 

·        Rescue My IRA year to date performance as of 9/30/2016: 6.39%

Next Month To-dos:
During September, I had to carefully manage six covered call trades that were expiring during the month.  I unwound two of these, and rolled out several of them, mostly to October, so this month starts with seven positions forecast to expire. 

Two positions are long-term under water:  NUE and XRX, so I am looking to roll them out and up; I’ve picked out some January strikes as my strategic targets for these.  If I am successful with those two, and the remaining five positions play out, the account will be most of the way to achieving my goal of 1% cash return during October. 

Four of the remaining five positions are narrowly out of the money, and one is in the money.  I can predict a busy month of either rolling out some of these or setting up new trades if they end up getting called away at expiration.

After all the dividends in September, there is only one position with an ex-dividend date in October.  The stock is T, and since the November contract I have on it is out of the money, I am forecasting that Rescue My IRA will collect that $96.00.

That’s it for the September update – as always, the results are reported net of commissions and fees.  Until next month, happy trading!