Dr. Alan Ellman | Feb 19, 2017 02:43AM ET
Selling cash-secured puts can be used to accomplish several goals;
Our strategy goal along with overall market assessment, chart technicals and personal risk tolerance will ultimately guide us to the most appropriate put strikes price to select. When viewing an options chain for puts it is apparent that in-the-money strikes (higher than current market value) will generate the highest premiums.
This is because there is both an intrinsic value component and a time value component. At-the-money and out-of-the-money strikes only have time value components to the option premiums. Let’s evaluate both in-the-money and out-of-the-money strikes for Veeva Systems, Inc. (NYSE:VEEV), a stock on our Premium Watch List at the time I am penning this article (we are viewing 3-week returns).
Put options chain for VEEV
With VEEV trading at $39.00 per share, I have highlighted the $37.00 out-of-the-money put strike and the $41.00 in-the-money put strike. Both strikes are precisely $2.00 from the current market value price of $39.00. On first glance, we see the $41.00 strike offers more than triple the premium than does the $39.00 strike but the question is which strike is best for our goals?
The BCI Put Calculator
First, notice that the time value components of both strikes are precisely the same. The out-of-the-money $37.00 put is all time value (0.85) and the in-the-money $41.00 put also has $0.85 of time value ($2.85 – $2.00). Given the equality of time value, the strike selection, to a great extent, will be based on our goals which must be identified prior to entering every trade.
Thought process leading to strike selection
Buying a stock at a discount
The in-the-money $41.00 strike will more likely be exercised (at a 2.18% discount). The $39.00 strike will only be exercised if share price drops below $39.00.
Using in conjunction with covered call writing
Since exercise is not an issue, both strikes are in play but since our goal is still cash generation, using the out-of-the-money strikes will give us sound returns and protection to the downside (7.31% in this case).
Using for cash flow only
Here we use the out-of-the-money puts. The more bullish we are, the closer to at-the-money we go. If we are strongly bullish I would favor out-of-the-money covered calls giving us the opportunity to generate two income streams in the same month with the same investment.
Discussion
The moneyness of put strikes is dictated by strategy goals, overall market assessment, chart technicals and personal risk tolerance. Selecting an in-the-money put strike to generate higher premiums is not a reason for strike selection because the loss of share value on the stock side will counterbalance the additional put premium.
Market tone
Global stocks continued moving higher on increasing evidence of improved US economic growth and rebounding inflation. Major US indices again rose to record highs during the week, oil prices dipped, with West Texas Intermediate crude at $53.50 a barrel versus $54.10 last week. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), edged up to 11.37 from 10.9. This week’s reports and international news of importance:
THE WEEK AHEAD
MONDAY, February 20th
TUESDAY, February 21st
WEDNESDAY, FEB. 22nd
THURSDAY, FEB. 23rd
FRIDAY, FEB. 24th
For the week, the S&P 500 was up by 1.39% for a year-to-date return of 4.89%.
Summary
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of November 10, 2016
BCI: I am currently fully invested and have an equal number of in-the-money and out-of-the-money strikes. I remain defensive despite all the positive signs based on the lack of clarity regarding the policies of the new administration.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) 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 8% while the VIX (11.37) declined by 6%.
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