Missed Chances Don’t Need to Hurt So Bad
Every investor, big and small, has had the sinking feeling of doing the homework on a stock, liking it, and deciding to buy, only to see it rally before placing the order. Conventionally, the strategy is to maintain entry-price discipline; nevertheless, “fear of missing out” is hard to resist and many investors end up buying at a higher price than they initially wanted.
Cash-covered puts allow investors to maintain entry-price discipline and get paid for it. The concept is very simple: if you intend to buy a certain stock at a pre-defined price (below current market) write a put-option that strikes at the entry price of your choice. The outcome is one of two: (i) if the stock falls below the strike, you buy the name at your intended entry point, or, (ii) if the stock stays strong, you missed the chance of owning it, but at least you keep the option premium. Naturally, if the stock price drops below the strike price, the strategy would mimic the downside of owning the stock outright: the investor loses money in the same way it would lose by owning the underlying shares.
Wait For the Pullback with Cash-Covered Puts
Let’s look at 4 securities to illustrate this example: (i) the SPY and QQQ ETFs which track the SP500 and Nasdaq indices, respectively; and (ii) TSLA and NFLX, as individual names that have had a torrid start to the year (up 60% and 20%, respectively). If we wanted to enter each of these names at a discount to current prices – 1.8% and 2.1% discount for the indices, 4.3% and 3.9% for the stocks — by Friday, February 24, we could write corresponding put option contracts:
One caveat to keep in mind: each option contract represents 100 shares so the minimum underlying will vary between $19k (TSLA) and $41k (SPY), which is the amount that ought to be kept in cash. Keeping the amount in cash is to cover the assignment of the option should the price drop below the strike.
In this example, the investor that writes 1 put contract for each of these names would receive $333 for SPY (0.8% of the underlying value to be bought), $379 for QQQ (1.2% of the underlying), $705 for TSLA (3.7% of the underlying), and $580 for NFLX (1.6% of the underlying).
What could go wrong with this type of strategy?
There are a few operational details to keep in mind. American options are “live wires” that can be triggered any time until expiration by the owner of the option, not by the one that writes the option. So, investors that write cash-covered puts may have to buy the stock at any time the buyer decides. Also, it is very important to keep live options “front of mind” until their expiration; investors have a much greater-than-expected tendency to put these options on the backburner. A strong way to mitigate these risks is to have the discipline to (a) always write options that expire within 2 weeks; and (b) make sure that you will be able to keep cash in the account during the period in which the option is live.
As a related segway, one may assume that the strategy of writing cash-covered puts to secure an entry point for buying shares could theoretically be extended to writing stock-covered calls to secure an exit point to sell shares. This is not accurate in practical terms. Cash-covered puts use cash as collateral — cash is fungible, easy to replace, and very liquid as a security. By contrast, stock-covered calls use equity shares as collateral, which are unique, irreplaceable, and exposed to event-driven liquidity problems. So, even though both strategies look very similar on an excel spreadsheet, in the marketplace, they carry materially different operational challenges and risks.
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