Using Cash-Secured Puts to Manage Stock Price Volatility
With significant price swings highly characteristic of equity markets in 2022, Solyco Wealth used cash-secured puts from the options markets to manage client portfolio volatility. We anticipate many opportunities to do so in 2023 likely will arise as well as volatility appears set to persist for the foreseeable future.
Cash-secured puts offer investors two benefits:
- In the event that the target stock remains above the strike price of the put contract, the investor retains the premium for which their originally sold the contract; and
- Should the stock price of the target company break below the strike price of the put contract, the investor may purchase the stock for the equivalent of the strike price minus the premium received for selling the original put contract.
The primary risk in writing or selling put options stems from the possibility that the share price of the target company may fall significantly below the strike price of the options contract. In the event of this occurrence, the investor has a significant choice to make in that they may buy-out their put option for the difference between the lower share price and the strike price of the option or they may buy the stock at a higher price than the recent market price (again, the option’s strike price minus the already-received premium). Hence, we arrive at Rule #1 for selling cash-secured put option contracts:
Do not sell cash-secured put option contracts on stocks one does not desire to own for the long-run.
Rule #1 also carries with it a corollary:
Do not use cash-secured put options unless sufficient cash exists in the account to buy shares of stock.
Engaging in the options market to participate in a specific stock may allow patient and disciplined investors to better manage price volatility by better defining the entry point for a specific equity. For instance, envision an investor that researched a particular stock and determined a target price of $165 for its shares. As those shares recently transacted at $137.50 each, representing 20% prospective upside, the investor decides to purchase 100 shares the following day. However, the company of interest announced the following morning before the market opened a positive development with a prospective new client: shares move much higher to the $145 level in pre-market trading. The investor, unwilling to chase this move higher as they incorporated the possibility of this new development in their $165 target price, maintains price discipline. Instead of waiting to purchase the shares on a pullback, the investor checks the put options market and discovers that a put expiring in one month with a $140 strike price offers a $2.50 premium. Thus, the investor may be able to replicate their original $137.50 purchase price.
Notably, this hypothetical participation in the put option market is not exactly the same as direct participation in the stock. In the event that the company’s shares continue to move higher, gains for the investor are capped at the $2.50 premium received for the put option they sold. The investor also does not participate in any dividends that the target company might pay out, unlike they would if they owned shares of the company outright.