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Investing in cash-secured puts (CSPs) and covered-calls is a cyclic process. Here's a flow-chart that captures the essence:
I was assigned a few positions this weekend after a few of my CSPs were in the money (ITM) as of yesterday's (2/5) close. What follows is an accounting of the math I'm using to show the CSP side of the equation, snapshot the picture facing me immediately after assignment, and see how to turn these into winning trades.
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Three stocks were assigned this past weekend: AMAT, MU, and SQ. I go into some detail on AMAT and the calculations, but condense this analysis for MU and SQ.
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First Assignment: AMAT
Rule 1 of CSPs: only sell puts on stocks that you would have no issues owning. AMAT is a quality stock in terms of EPS and revenue growth.
I sold the weekly AMAT 180209P50 on 2/5 for a credit of $41.00 ($0.41 * 100). At the time the price was $51.35, and the historical volatility was 43%.
If the price closed above $50 the unexercised return on the option (UROO) would have been 0.81% including commissions; I typically try to buy these back at $0.05 or $0.10. Using the $0.05 value my actual closed return on the option (CROO) would have been 0.69%. The annualized return on the option (AROO) using the forced closed numbers, and knowing there are only 4 days that the order is alive, results in a AROO calculation of 62.54% ( = CROO * 365 / # days to exp ), including round-trip commissions ($2 total).
If assigned, breakeven for the stock is the strike price minus premium + commission, or $50 - $0.41 + 0.01 = $49.60.
The underlying closed ITM at $48.35, so the stock was assigned to me overnight. The average price from my broker is the strike price of the put, in this case, $50.00/share.
Any rise in the price above $49.60 is profit. If I sell a call against it, as long as the call is above $49.60 (less the premium received), I'll make money.
So, what to do next?
AMAT is coming up on an earnings release next week, Wednesday, Feb 14, after the close (ATC).
I'm slightly bullish on AMAT in terms of REV and EPS, so I think it will bump to the upside.
I'm slightly bullish on AMAT in terms of REV and EPS, so I think it will bump to the upside.
There are a couple of ways to calculate an expected move:
(1) The first way to calculate the range is to see what the market thinks the current range could be. Of course, this needs to be recalculated just before earnings release, and that's not always feasible (it certainly is not for me). In general, the expected trade range can be calculated using a short at-the-money (ATM) credit straddle, multiplying this by 0.85 (see this link), and then adding/subtracting it to the current price. The $48.50 strike has a call bid of $1.63 and the put bid is at $2.13. Doing the math shows that we could see a move of +/- $3.20 or so if the earnings report was tomorrow. This gives us a rough expected range of $45.15 to $51.55. Using this method, as long as my call is above $51.55, there would only be a 32% chance of having the position called away (e.g. a 68% chance exists that the price would be below the strike if it were perfectly at $51.55).
(2) Method 2 is the same as method (1) above but does not multiply by the 0.85. Link here. This suggests that we have the credits for the ITM short call and put totalling $3.76 and with the last close of $48.35, the implied volatility is 7.78% with 7 days to go (3.76/48.35). Multiplying the last close by 1.0778 = $52.11.
Method 2 is more conservative so I'm going to use that for now.
So, it appears as long as I have a strike above $52.11 there will be a better than 68% chance that I will be out of the money (OTM) on expirations day.
The delta of a specific option can be taken as the percent likelihood that the position will finish ITM. This is not an exact 1:1 relationship, but it's close enough, certainly to the nearest 10% or so.
(2) Method 2 is the same as method (1) above but does not multiply by the 0.85. Link here. This suggests that we have the credits for the ITM short call and put totalling $3.76 and with the last close of $48.35, the implied volatility is 7.78% with 7 days to go (3.76/48.35). Multiplying the last close by 1.0778 = $52.11.
Method 2 is more conservative so I'm going to use that for now.
So, it appears as long as I have a strike above $52.11 there will be a better than 68% chance that I will be out of the money (OTM) on expirations day.
The delta of a specific option can be taken as the percent likelihood that the position will finish ITM. This is not an exact 1:1 relationship, but it's close enough, certainly to the nearest 10% or so.
I like any delta less than +0.3 for selling calls and less than -0.3 for selling puts. I also require that any call or put I purchase have an AROO in excess of 20% (annualized).
5 trading days exist between me and expirations. If I require an annualized return of at least 20% and I have only 5 days left, the equation is:
20% * 5 / 365 = CROO (Closed Return on Option) = 0.27%
So, any premium that results in me getting at least 0.27% in 5 days is worthy of my efforts.
My cost basis on the stocks is my break-even * 100 shares, or $4,960.
0.27% of my cost basis is $13.59, or $0.14. Because there is a $1 commission in here I'll add another $0.01 to show I need at least an option premium of $0.15 to make this 20% minimum.
So, here's the criteria for selling the call:
1) It has to be of a strike higher than $52.11. This implies at least $52.50 or $53.
2) Whatever the strike, I have to collect at least $15, and prefer to do it with a delta under 0.3.
One (laborious) way I do this is plot the bid/ask midpoints/delta for each of the call strikes, and look for discontinuities in the curve. Here's an example for AMAT and call options that expire on 2/16 (this week):
This plot shows the change in premium received / change in delta for each strike, as well as the raw premium received / delta. As you would expect, as the strike moves further away from today's price the delta drops, and we also see that the premium received also drops. The ratio is not constant though, and as we get further OTM premium drops faster than delta. This can be interpreted "less chance of a strike being ITM, the lower the premium received". The red dots are almost in a straight line, but the blue dots are not.
It doesn't always look like this, but the discontinuity for selling an AMAT call at strike = $53 (at a delta of 0.1648, not shown), is kind of a beacon to me to sell this strike. It basically says "there is an 84% chance that anything you collect here will be pocketed, and although you may collect more at the $52.50 strike, the risk is disproportionate."
Think about it. The blue dot is change in premium received from the next lower strike / change in delta. So, when moving from the 52.50 strike to the 53 strike, EITHER the premium did not drop as much or the risk (delta) went down far more than expected. Discontinuities do not last long in the market so the midpoint price (bid = $0.42 and ask = $0.31) of $0.36 could be a limit sell of $0.30 and still I would make all my targets.
Whatever the cause, the $53 strike calls for me.
A final check is to ensure that there is open interest (OI) at the strike. The $53 call in AMAT has 717 contracts as I write this.
The order will be STO 1 AMAT 180216C53 Limit $0.30 DAY.
AMAT Trade Analysis
If the price of AMAT rises above $53, I'll make $300 from the stock appreciation (put to me at $50 and called away at $53), plus the premium from the CSP of + $40 (incl comm), plus this CC premium of $29 (premium of $30 less $1 comm), so $69 in total premiums, for a total of $369. The original amount invested was $5000 on 2/5 (cash secured put), so for 12 total days the annualized return is (369/5000) * 365/12 = 224%.
If the price of AMAT is above $50 but below $53 then I'll still have the amount above $50 as paper profit plus the banked premium of the CSP ($40 incl comm), plus the banked CC premium of $29 (incl comm). The call will expire worthless and I keep the premium. The AROO for this premium ($29 incl comm) and amount tied up ($5,000) is 42.34% (29/5000*365/5). I could sell the shares on the market to collect the paper profit or I could sell another call against the underlying.
If the price of AMAT is below my new break even of $49.60 - 0.29 = $49.31 or lower I'll still be underwater (but owning a quality stock). I keep all the premiums and will sell another call to further lower my basis.
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2nd Assignment: MU
I sold MU 180209P41 on 1/29 for a credit of $0.45. With 11 days to expiration, the unexercised return on option (UROO) was 1.09%, the closed return on option (CROO) was 0.94%, and the annualized return on option (AROO) if I closed early at $0.05 would have been 31.08%. At the time there was a 78% chance that the option would close OTM. I sold the -0.2234 delta. My break-even for the position is $40.56, including commission.
MU closed at $40.54, below the strike of $41, so the stock was put to me.
MU does not report earnings until Thursday, March 22nd, after the close, so there is nothing there to worry about in terms of impact.
Let's take a look at the expected range of MU for the next week:
Short Call bid: 1.07
Short Put bid: 1.67
Total: 2.74
Expected range: 37.80 to 43.28
My target is selling a call at the 43.50 strike or higher.
Here is the plot of "change in premium vs change in delta" for various strikes:
I've put the arrow on the 44 strike because you can see that at lower strikes, the blue dots are below this level -- reward / risk is improving, on a percentage basis, for the $44 and $44.50 strikes, relative to the $43 and the $43.50 strikes.
Yes, I acknowledge that I collect more premium at the $43 and $43.50 strikes, but it's at a higher delta, and this is a higher risk / lower probability that I'll be OTM.
The $44 strike has a delta of 0.163 as I write and a midpoint (premium) target of $0.27.
As from my analysis with AMAT, I am looking to ensure I have at least 20% AROO in the trade. With 5 days to expiration, 20% * 5 / 365 = CROO (Closed Return on Option) = 0.27%
So, any premium that results in me getting at least 0.27% in 5 days is worthy of my efforts.
My cost basis on the stocks is my break-even * 100 shares, or $4,056.
0.27% of my cost basis is $10.95, or $0.11/share. Because there is a $1 commission in here I'll add another $0.01 to show I need at least an option premium of $0.12 to make this 20% minimum. This is well above the $0.27 midpoint at the $44 strike so this delta works.
A final check is to ensure that there is open interest (OI) at the strike. The $44 call in MU has 22,054 contracts as I write this.
The order will be STO 1 MU 180216C44 Limit $0.25 DAY.
MU Trade Analysis
If the price of MU rises above $44, I'll make $300 from the stock appreciation (put to me at $41 and called away at $44), plus the premium from the CSP of + $44 (incl comm), plus this CC premium of $24 (premium of $25 less $1 comm), so $68 in total premiums, for a total of $368. The original amount invested was $4,100 on 1/29 (cash secured put), so for 19 total days the annualized return is (368/4100) * 365/19 = 172%.
If the price of MU is above $41 but below $44 then I'll still have the amount above $41 as paper profit plus the banked premium of the CSP ($44 incl comm), plus the banked CC premium of $24 (incl comm). The call will expire worthless and I keep the premium. The AROO for this premium ($24 incl comm) and amount tied up ($4,100) is 42.73% (24/4100*365/5).I could sell the shares on the market to collect the paper profit or I could sell another call against the underlying.
If the price of MU is below my new break even of $40.56 - 0.24 = $40.32 or lower I'll still be underwater (but owning a quality stock). I keep all the premiums and will sell another call to further lower my basis.
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3rd Assignment: SQ
I sold SQ 180209P41.5 on 1/29 for a credit of $0.30. With 11 days to expiration, the unexercised return on option (UROO) was 0.73%, the closed return on option (CROO) was 0.61%, and the annualized return on option (AROO) if I closed early at $0.05 would have been 20.13%. At the time there was a 88% chance that the option would close OTM. I sold the -0.131 delta. My break-even for the position is $41.21, including commission.
SQ closed at $39.75, below the strike of $41.50, so the stock was put to me.
SQ does not report earnings until Tuesday, February 27th, after the close, so there is nothing there to worry about in terms of impact.
Let's take a look at the expected range of MU for the next week:
Short Call bid: 1.35
Short Put bid: 1.45
Total: 2.80
Expected range: 36.90 to 42.55
My target is selling a call at the 43 strike or higher.
Here is the plot of "change in premium vs change in delta" for various strikes:
I've put the arrow on the $43 strike because you can see that at lower strike of $42.50, the blue dot is below this level -- reward / risk is improving, on a percentage basis, for the $43 and $43.50 strikes, relative to the $42.50 strike.
Yes, I acknowledge that I collect more premium at the $42.50 strike, but it's at a higher delta, and this is a higher risk / lower probability that I'll be OTM. I do not mind holding a quality stock like SQ.
The $43 strike has a delta of 0.2179 as I write and a midpoint (premium) target of $0.45.
As from my analysis with AMAT and MU, I am looking to ensure I have at least 20% AROO in the trade. With 5 days to expiration, 20% * 5 / 365 = CROO (Closed Return on Option) = 0.27%.
So, any premium that results in me getting at least 0.27% in 5 days is worthy of my efforts.
My cost basis on the stocks is by break-even * 100 shares, or $4,121.
0.27% of my cost basis is $11.13, or $0.12/share. Because there is a $1 commission in here I'll add another $0.01 to show I need at least an option premium of $0.13 to make this 20% minimum. This is well above the $0.45 midpoint at the $43 strike so this delta works.
A final check is to ensure that there is open interest (OI) at the strike. The $43 call in SQ has 3,681 contracts as I write this.
The order will be STO 1 SQ 180216C43 Limit $0.40 DAY.
SQ Trade Analysis
If the price of SQ rises above $43, I'll make $150 from the stock appreciation (put to me at $41.50 and called away at $43), plus the premium from the CSP of + $29 (incl comm), plus this CC premium of $39 (premium of $40 less $1 comm), so $68 in total premiums, for a total of $218. The original amount invested was $4,150 on 1/29 (cash secured put), so for 19 total days the annualized return is (218/4150) * 365/19 = 101%.
If the price of SQ is above $41.50 but below $43 then I'll still have the amount above $41.50 as paper profit plus the banked premium of the CSP ($29 incl comm), plus the banked CC premium of $39 (incl comm). The call will expire worthless and I keep the premium. The AROO for this premium ($39 incl comm) and amount tied up ($4,150) is 68.60% (39/4150*365/5). I could sell the shares on the market to collect the paper profit or I could sell another call against the underlying.
If the price of SQ is below my new break even of $41.21 - 0.39 = $40.82 or lower I'll still be underwater (but owning a quality stock). I keep all the premiums and will sell another call to further lower my basis.
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So, that's the plan going into next week. Whether it works out is for all of us to see.
If you see anything wrong in my calculations, please let me know. I think I have all of the bugs out of the spreadsheet that I used, but ya never know until others look at it.
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As with all my ramblings, you are responsible for your own investment decisions and I am not. Please do your own diligence, and please take ownership for your actions.
Regards,
pgd
AMAT Trade Analysis
If the price of AMAT rises above $53, I'll make $300 from the stock appreciation (put to me at $50 and called away at $53), plus the premium from the CSP of + $40 (incl comm), plus this CC premium of $29 (premium of $30 less $1 comm), so $69 in total premiums, for a total of $369. The original amount invested was $5000 on 2/5 (cash secured put), so for 12 total days the annualized return is (369/5000) * 365/12 = 224%.
If the price of AMAT is above $50 but below $53 then I'll still have the amount above $50 as paper profit plus the banked premium of the CSP ($40 incl comm), plus the banked CC premium of $29 (incl comm). The call will expire worthless and I keep the premium. The AROO for this premium ($29 incl comm) and amount tied up ($5,000) is 42.34% (29/5000*365/5). I could sell the shares on the market to collect the paper profit or I could sell another call against the underlying.
If the price of AMAT is below my new break even of $49.60 - 0.29 = $49.31 or lower I'll still be underwater (but owning a quality stock). I keep all the premiums and will sell another call to further lower my basis.
~~~~~~~~~~~~
2nd Assignment: MU
I sold MU 180209P41 on 1/29 for a credit of $0.45. With 11 days to expiration, the unexercised return on option (UROO) was 1.09%, the closed return on option (CROO) was 0.94%, and the annualized return on option (AROO) if I closed early at $0.05 would have been 31.08%. At the time there was a 78% chance that the option would close OTM. I sold the -0.2234 delta. My break-even for the position is $40.56, including commission.
MU closed at $40.54, below the strike of $41, so the stock was put to me.
MU does not report earnings until Thursday, March 22nd, after the close, so there is nothing there to worry about in terms of impact.
Let's take a look at the expected range of MU for the next week:
Short Call bid: 1.07
Short Put bid: 1.67
Total: 2.74
Expected range: 37.80 to 43.28
My target is selling a call at the 43.50 strike or higher.
Here is the plot of "change in premium vs change in delta" for various strikes:
I've put the arrow on the 44 strike because you can see that at lower strikes, the blue dots are below this level -- reward / risk is improving, on a percentage basis, for the $44 and $44.50 strikes, relative to the $43 and the $43.50 strikes.
Yes, I acknowledge that I collect more premium at the $43 and $43.50 strikes, but it's at a higher delta, and this is a higher risk / lower probability that I'll be OTM.
The $44 strike has a delta of 0.163 as I write and a midpoint (premium) target of $0.27.
As from my analysis with AMAT, I am looking to ensure I have at least 20% AROO in the trade. With 5 days to expiration, 20% * 5 / 365 = CROO (Closed Return on Option) = 0.27%
So, any premium that results in me getting at least 0.27% in 5 days is worthy of my efforts.
My cost basis on the stocks is my break-even * 100 shares, or $4,056.
0.27% of my cost basis is $10.95, or $0.11/share. Because there is a $1 commission in here I'll add another $0.01 to show I need at least an option premium of $0.12 to make this 20% minimum. This is well above the $0.27 midpoint at the $44 strike so this delta works.
A final check is to ensure that there is open interest (OI) at the strike. The $44 call in MU has 22,054 contracts as I write this.
The order will be STO 1 MU 180216C44 Limit $0.25 DAY.
MU Trade Analysis
If the price of MU rises above $44, I'll make $300 from the stock appreciation (put to me at $41 and called away at $44), plus the premium from the CSP of + $44 (incl comm), plus this CC premium of $24 (premium of $25 less $1 comm), so $68 in total premiums, for a total of $368. The original amount invested was $4,100 on 1/29 (cash secured put), so for 19 total days the annualized return is (368/4100) * 365/19 = 172%.
If the price of MU is above $41 but below $44 then I'll still have the amount above $41 as paper profit plus the banked premium of the CSP ($44 incl comm), plus the banked CC premium of $24 (incl comm). The call will expire worthless and I keep the premium. The AROO for this premium ($24 incl comm) and amount tied up ($4,100) is 42.73% (24/4100*365/5).I could sell the shares on the market to collect the paper profit or I could sell another call against the underlying.
If the price of MU is below my new break even of $40.56 - 0.24 = $40.32 or lower I'll still be underwater (but owning a quality stock). I keep all the premiums and will sell another call to further lower my basis.
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3rd Assignment: SQ
I sold SQ 180209P41.5 on 1/29 for a credit of $0.30. With 11 days to expiration, the unexercised return on option (UROO) was 0.73%, the closed return on option (CROO) was 0.61%, and the annualized return on option (AROO) if I closed early at $0.05 would have been 20.13%. At the time there was a 88% chance that the option would close OTM. I sold the -0.131 delta. My break-even for the position is $41.21, including commission.
SQ closed at $39.75, below the strike of $41.50, so the stock was put to me.
SQ does not report earnings until Tuesday, February 27th, after the close, so there is nothing there to worry about in terms of impact.
Let's take a look at the expected range of MU for the next week:
Short Call bid: 1.35
Short Put bid: 1.45
Total: 2.80
Expected range: 36.90 to 42.55
My target is selling a call at the 43 strike or higher.
Here is the plot of "change in premium vs change in delta" for various strikes:
I've put the arrow on the $43 strike because you can see that at lower strike of $42.50, the blue dot is below this level -- reward / risk is improving, on a percentage basis, for the $43 and $43.50 strikes, relative to the $42.50 strike.
Yes, I acknowledge that I collect more premium at the $42.50 strike, but it's at a higher delta, and this is a higher risk / lower probability that I'll be OTM. I do not mind holding a quality stock like SQ.
The $43 strike has a delta of 0.2179 as I write and a midpoint (premium) target of $0.45.
As from my analysis with AMAT and MU, I am looking to ensure I have at least 20% AROO in the trade. With 5 days to expiration, 20% * 5 / 365 = CROO (Closed Return on Option) = 0.27%.
So, any premium that results in me getting at least 0.27% in 5 days is worthy of my efforts.
My cost basis on the stocks is by break-even * 100 shares, or $4,121.
0.27% of my cost basis is $11.13, or $0.12/share. Because there is a $1 commission in here I'll add another $0.01 to show I need at least an option premium of $0.13 to make this 20% minimum. This is well above the $0.45 midpoint at the $43 strike so this delta works.
A final check is to ensure that there is open interest (OI) at the strike. The $43 call in SQ has 3,681 contracts as I write this.
The order will be STO 1 SQ 180216C43 Limit $0.40 DAY.
SQ Trade Analysis
If the price of SQ rises above $43, I'll make $150 from the stock appreciation (put to me at $41.50 and called away at $43), plus the premium from the CSP of + $29 (incl comm), plus this CC premium of $39 (premium of $40 less $1 comm), so $68 in total premiums, for a total of $218. The original amount invested was $4,150 on 1/29 (cash secured put), so for 19 total days the annualized return is (218/4150) * 365/19 = 101%.
If the price of SQ is above $41.50 but below $43 then I'll still have the amount above $41.50 as paper profit plus the banked premium of the CSP ($29 incl comm), plus the banked CC premium of $39 (incl comm). The call will expire worthless and I keep the premium. The AROO for this premium ($39 incl comm) and amount tied up ($4,150) is 68.60% (39/4150*365/5). I could sell the shares on the market to collect the paper profit or I could sell another call against the underlying.
If the price of SQ is below my new break even of $41.21 - 0.39 = $40.82 or lower I'll still be underwater (but owning a quality stock). I keep all the premiums and will sell another call to further lower my basis.
~~~~~~~~~~~~
So, that's the plan going into next week. Whether it works out is for all of us to see.
If you see anything wrong in my calculations, please let me know. I think I have all of the bugs out of the spreadsheet that I used, but ya never know until others look at it.
~~~~~~
As with all my ramblings, you are responsible for your own investment decisions and I am not. Please do your own diligence, and please take ownership for your actions.
Regards,
pgd
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