The Strike Price – Trade Of the Week

Okay, I’ve recently discussed cash-secured puts so it only makes sense to go over a trade using the strategy.
Remember, while I am using real prices, the trades mentioned are purely examples used to help conceptualize the ins-and-outs of the strategy discussed. Trade at your own risk….but you know that already, right?
When I trade cash-secured puts or sell puts on margin, I prefer to wait until a stock or ETF with highly-liquid options hits an oversold state. It gives me a slight edge due to the laws of mean-reversion.

Due to the recent spike in the underlying market, there really aren’t many good choices at the moment. Wal-Mart (WMT) qualifies, kind of, because the RSI (2), the shortest-term duration is monitor for my overbought/oversold indicator, is in an oversold state. The RSI (5) sits at 39.91, slightly above an oversold state. I would prefer to see the RSI (2) and (5) in an oversold state, but obviously that is not the case in this example.
After finding a good candidate I move on to the options chain to simply look at the probability of success and the associated premium.
But first I need to decide on my duration. I like to use the shortest time frame that allows me to bring in a decent amount of premium. “Decent premium” will obviously differ with each individual trader. And each individual trader might have a different risk/reward from one trade to the next.

I’ve chosen a longer duration trade for WMT, mostly because the implied volatility is low and I can’t really bring in decent premium at shorter durations. In many cases, a trade situation similar to this WMT trade might actually might lead me to pass on a trade.
But we’re pushing forward, we’re going through the process, we’re learning.
So, when selling cash-secured puts, I like to choose a probability of success of roughly 85% and I like to bring in at least 1%, preferably more.
So given those requirements I would first look at the Apr 77.5 puts as they have a probability of success of 85.74%. But with a premium of that falls somewhere between $0.44 and $0.53 (I would choose a limit price of $0.47 to $0.48), we can only bring in roughly 0.5% over 60 days. An extra 3.0% annually that would act as a source of income or to just simply lower the cost basis of the stock by 3.0%.
But, the premium at the 85% probability of success doesn’t work for me in this situation. I want to bring in at least 1%. So I’ll move up 2.5 strikes to the 80 puts. The 80 puts have a 78.26% probability of success and I can realistically sell a put in there for probability $0.78 which leads to a return of 0.98%…close enough.
Of course I could sell the 82.5 puts with a 66.87% probability of success for a 1.6% return, but the 66% probability of success is below my line in the sand.
What is my line in the sand? 68%. Why? Because 68% is one standard deviation away from the current price of the underlying. Of course, it’s just a personal choice and that’s what we need to remember when trading…you must find what works for you and your trading style.
So, back to the trade. I’m going with the 80 puts.
Basically I can sell the 80 puts due to expire in 60 days for a premium of 0.98%….roughly 6% a year. Not the greatest return, but when you factor in that we are using a relatively stable stock as seen by the low volatility in the options chain above (19.12%) the return begins to look more reasonable, especially if you want to actually own the stock.
Just think if you waited a year for a stock to a limit price. That’s what most investors do and they lose out on decent returns. Remember, the worst that can happen is that we are assigned WMT stock at $80 a share, and in most cases, that is an area where we are comfortable owning the stock.
As I said before, cash-secured puts are a great way to either lower your cost basis or to simply provide safe, steady income. It’s your choice, but you have to make the plunge into the world of options just to see how powerful these strategies are for all levels of investors.
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