Tuesday, October 4, 2016
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.