Cash Secured Put Strategy
A cash secured put is a risk management strategy that involves selling a put and investing on a short term basis, the money for the purchase of stock. A premium for selling the put option is paid to the investor while waiting for the stock to decline to desired price at which the investor is ready to own the stock (Smith, 2008). The strategy allows investor to accumulate the stock at a lower price than is currently trading.
With a portfolio of 40,000 and the investor decides to acquire LifePoint Health (NASDAQ: LPNT) currently trading at $64.35 and believes that in August of this year, the stock will be trading at $60, the investor will enter an order to sell LPNT put with a $60 strike ("NASDAQ : A-Z Company Listing :," n.d.) The investor will have the obligation to buy the stock at $60 should the buyer of the option exercise the right to sell LPNT. The investor would sell one put for every 100 shares of stock he is ready to purchase. Suppose the investor sells 6 LPNT August 18th $60 puts at $3.00 when the stock is trading at $64.35. At expiration, the stock will either be above $60 in which case the investor will not buy the stock or below $60 in which the investor is to buy the stock at $60. Having sold the puts at a strike of $60, should LPNT decline considerably the investor still has the obligation to buy the stock at $60 though he will receive a reduction of the $3.00 premium received from sale.
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| August 18th |
Action |
| Strike price above $60 | No stock is bought and investor keeps a premium of $3.00*6*100=$1800 |
| Strike price below $60 | The investor will own 621 shares at $60. The net cost per share will be $57.00 ($60-$3.00) |
A cash secured put allows the investor to be paid a premium for the obligation to buy a particular stock. The premium received offers downside protection. The rate of return from the cash secured strategy is the equal to the premium received from selling the put and the opportunity to buy the stock for a lower cost than is currently trading. When the option maturity is before August of this year, new cash secured put can be entered to. The return from cash secured put when the strike price is above $60 is the premium kept of $1800 which gives a return of 4.5%. When the strike price is below $60, the return is 5%.
Covered Call Strategy
A covered call is a risk management strategy that involves the holder of the underlying stock selling a call on the underlying stock. The strategy allows the investor to generate income from the written call option premium and also dividends from the stock (Hull, 2014) . If the covered call is exercised, the underlying stock will be delivered to the call option holder and the covered call writer receives an amount equal to the exercise price multiplied by the number of calls exercised. If the covered call is not exercised, the covered call writer keep the premium received for selling the calls and still own the underlying stock. A covered call strategy is used when the investor is moderately bullish on a stock he intends to own.
With a portfolio of 40,000 and the investor decides to acquire LifePoint Health (NASDAQ: LPNT) currently trading at $64.35 and believes that in August of this year, the stock will be trading at $70. August 18th $70 calls will be sold at $2.20. By selling August 18th call, the investor is agreeing to sell LPNT at $70 if the owner of the call decides to exercise the right to buy LPNT. Should LPNT remain below $70, the option will expire worthless and the premium of $2.20 and stock position will be retained by the call writer. When LPNT rises above $70, the call buyer can exercise the right to buy the stock and the call writer would have to sell LPNT at $70.
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Action |
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Strike price above $70 |
Investment is 40000 and premium received is 40000/64.35=621 shares and 621/100 = 6 calls. 6 calls*2.20=$13.20 |
| The net investments is 40000-13.20= 39,986.80 | |
| Amount received is 621shares at $70= 43,470 | |
| The return is 43,470/39,986.80 is 8.71% |
A covered call allows the investor to be paid for writing an option that has an obligation to selling a particular stock at a specified price. When the option maturity is before August of this year, new covered call transaction can be entered to. The return for a covered call when the strike price is above $70 is 8.71%. Covered call when compared to cash secured put is yielding a higher return. Therefore the investor should seek to implement a covered call strategy.
Both cash secured put and covered call strategies involves the call writer receiving a call premium for the obligation to selling and buying a stock respectively. Both strategies allow for generation of income in an actively managed portfolio and provides some amount of downside protection which is only limited to the option premium. Under both strategies, the profit potential is limited when volatility is higher and the stock prices moves higher.
References
Hull, J. C. (2014). Fundamentals of futures and options markets . Upper Saddle River, NJ: Pearson Education, Inc.
NASDAQ : A-Z Company Listing :. (n.d.). Retrieved from http://www.advfn.com/nasdaq/nasdaq.asp
Smith, C. (2008). Option strategies: Profit-making techniques for stock, stock index, and commodity options . Hoboken, NJ: Wiley.
