Dr. Alan Ellman | Sep 17, 2017 01:02AM ET
Selling cash-secured puts requires us to master the three required skills: stock (or ETF) selection, option selection and position management. This article will highlight how to select a put strike based on our overall market assessment.
Market assessment data published in BCI newsletters
Each investor must establish criteria for determining market tone and categorize this parameter as bullish, neutral or bearish.
Pros and cons of various put strikes
For most of us who use puts to generate monthly (or weekly) cash flow or to buy stocks at a discount, we focus in on out-of-the-money put strikes. These are strike prices lower than current market value. In addition to generating put premium income, we will also have downside protection if share price should decline. Near-the-money (slightly below current market value) will generate the highest initial premium returns but give us the smallest amount of downside protection. These should be favored in neutral to bull market environments. Deeper out-of-the-money put strikes (much lower than current market value) should be considered in bear or volatile market scenarios.
We must first set a range for initial premium returns. Let’s say our range for initial returns is from 1-4% per month. To evaluate a real-life example, I have selected Applied Materials (NASDAQ:AMAT), a stock on our Premium Stock List as of 5/17/2017.
Options chain for AMAT as of 5/17/2017
With AMAT trading at $43.56 on 5/17/2017, we view the out-of-the-money $43.00, $42.00, $41.00 and $40.00 strikes. The published bid prices range from $1.42 to $0.48 per share. Note that the bid-ask spreads are small so negotiating with the market-makers by leveraging the Show or Fill Rule does not apply here. The deeper out-of-the-money we go, the lower the option premium. Next, we enter this information into the BCI Put Calculator (click on link for a free copy of the single-column BCI Put Calculator) :
Put calculations for AMAT as of 5/17/2017
Let’s focus in on the two extremes, the $43.00 closest-to-the-money strike and the $40.00 furthest-from-the-money strike.
$43.00 put strike
This strike generates an unexercised return of 3.42% or 41.55% annualized. If exercised, shares are purchased at a cost basis of $41.58 or a 4.55% discount from the original price of $43.56.
$40.00 put strike
This strike generates an unexercised return of 1.21% or 14.78% annualized. If exercised, shares are purchased at a cost basis of $39.52 or a 9.27% discount from the original price of $43.56.
Matching strikes with market assessment
In a bull market environment, we would favor the $43.00 which yields a higher unexercised return. With a positive market tone, shares are less likely to move below the strike. In a bear market, we would favor the $40.00 strike where share value would have to decline by more than 9.27% before we start losing money. View these decisions as a negotiation where we base our choices on the tone of the market at the time. We can adjust on a monthly basis. Chart technical will also play a role in our bullish/bearish strike price decisions.
Discussion
One of the main parameters we use when selecting strikes for put-selling (as well as covered call writing) is overall market tone. The deeper out-of-the-money we go, the lower the returns but the more downside protection we have. The closer to-the-money we go, the higher the initial returns and the lower the downside protection. One size does not fit all.
DuPont (NYSE:DWDP) has a new ticker symbol
DD is now DWDP: DuPont from our Blue Chip Report:
Shares of DuPont and Dow ceased trading at the close of the New York Stock Exchange (NYSE) on Aug. 31, 2017. DowDuPont will start trading on the New York Stock Exchange under the stock ticker symbol DWPD. Pursuant to the merger agreement, Dow shareholders received a fixed exchange ratio of 1.00 share of DowDuPont for each Dow share, and DuPont shareholders received a fixed exchange ratio of 1.282 shares of DowDuPont for each DuPont share.
Market tone
Global stocks rose modestly this week. The price of West Texas Intermediate crude oil rose to $49.87 from last Friday’s 47.59 while the Chicago Board Options Exchange Volatility Index (VIX) declined to 10.17 from 12.34. This week’s economic and international news of importance:
THE WEEK AHEAD
Mon, Sep 18th
Tue, Sep 19th
Wed, Sep 20th
Thu, Sep 21st
Fri, Sept 22nd
For the week, the S&P 500 rose by 1.58% for a year-to-date return of 11.68%
Summary
IBD: Market in confirmed uptrend
GMI : 6/6- Buy signal since market close of August 31, 2017
BCI: I am currently favoring in-the-money strikes 2-to-1.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND CBOE Volatility Index) ARE TELLING US
The 6-month charts point to a neutral to slightly bullish outlook. In the past six months, the S&P 500 was up 5% while the VIX (10.17) moved down by 12.5%.
Much success to all,
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