One of the questions which came out of our recent webinar was to elaborate on the cash secured put. Specifically, aren’t put sale trades riskier than other options trades and should be avoided “unless you really know what you are doing”? I agree you need to know what you are doing before committing any capital to any stock or option trade.
I also thought the question was a good subject for this blog.
If you missed last week’s webinar it can be viewed here: OptionsHouse Strategy Webinar with Dan Sheridan: Managing a $20,000 Options Portfolio for Monthly Income.
Dear OptionsHouse Webinars,
I enjoyed the webinar on Trading a $20,000 account. It was helpful to me since I work with a small account by most standards. I was a little confused on the last trade he described. Was he in fact showing a selling of a naked put position? I have always been taught that you do not sell naked options unless you really know what you are doing. Perhaps you can elaborate.
Thank you for your interest in our recent webinar trading a 20,000 dollar account for monthly income. Your concern about one of the strategies described, the cash secured put, being extremely risky is one I hear a great deal. While all option trades involve risk and are not suitable for all investors, the Cash secured put has benefits and risks which are similar to another strategy which most new traders describe as conservative.
Toward the end of our webinar, Dan Sheridan was talking about selling a naked (cash secured) put. You are also correct that many option educators out there think that is the absolute LAST trade anyone should do! The same educators teach that the covered call strategy is a nice conservative strategy appropriate for risk adverse accounts. In my opinion, those educators couldn’t be more wrong. I would agree with you that you need to know what you are doing before entering into any option trade.
The risk is essentially the same for the two strategies covered calls and short puts. If you will look at a parity graph you will see this immediately.
A covered call parity graph shows that your max profit is capped at the strike price sold and the risk of loss is to the downside due to the long stock position.
A short put the max profit again is capped above the short put strike and the risk of loss is below to the downside due to the fact you are obligated to buy stock at strike.
Here is a parity graph – what is this a picture of? The short put or the covered call?
You cannot tell. The risk is the same below the short strike of 125.
The key in the short put example in last week’s webinar, you have to pick a stock or ETF which you are comfortable buying the stock at the strike price you have chosen to short a put. If you are doing this in a Cash account, such as an IRA you must keep a cash balance which secures that obligation to purchase at that strike price.
Not a buy recommendation but an example – say you wanted to buy TWTR stock at $28 if the shares continued to fall. You could consider selling the $28 puts expiring in September for $2.10. You need to have $28 X 100 = $2,800.00 in your account to secure the obligation you may have to purchase the shares. You can of course use the $210 in premium you receive for selling the stock. So the total amount of cash you need or your actual potential cost of buying the stock would be $28 – $2.10 = $25.90 per share X 100 shares = $2,590.00 plus any commissions and fees.
The maximum profit from this trade is the premium you received of $210. The max risk of loss is if TWTR continues to fall and hits zero or $2,590.00. Remember you will only buy the stock if the shares fall below $28.
Dan Sheridan also mentioned in higher priced stocks, the cash required to secure the put sale can be large. To lower the requirement, buying a further out of the money put will limit the downside risk and reduce the amount of capital which is required to secure the short put. This strategy is called a credit put spread.
You can find webinars of these strategies with specific detailed information in our webinar archives.
All the best,
Chief Investment Strategist