How to Correctly Select a Cash Secured Put

This article is aimed at answering the question of how to properly select a candidate for a cash secured put. We are going to first look at two different underlying issues and then we will highlight the reasons why one is better than the other.
This article builds on the assumption that the readers are already familiar with the basic concepts behind using cash secured puts.

Part 1

Cash Secured Put on AMZN @ 239.30

Starting with the chart above, on Friday 09-16-2011, AMZN closed at 239.30 and we have selected 220 as a horizontal trend line that has acted in the past as both resistance (twice) and support (also twice). The higher level of 230 was not selected because the 230 level did not have as many touches as the 220 level did.

The strike price which was selected as the sale candidate was the Sep weekly 220 put. Please notice that between the current price 239.30 and the sold 220 put we have 19.30 of protection. However, to that amount we also need to add the additional credit which we receive by selling the Sep weekly 220 put for 0.95 cents. Therefore, we have 19.30 protection plus the credit of 0.95 which gives us protection of over 20 dollars.

PART I - A

Next, let us look at the current Average True Range reading. The question becomes which ATR do we really need to pay attention to? Is it the daily or weekly? The Daily ATR = 7.37 while the Weekly ATR = 17.85, so taking into account that we are looking at selling the weekly option, it makes perfect sense to take the weekly ATR of 17.85 into consideration. Hence, let us play out the scenario that AMZN does not go up as anticipated, but comes down in the amount of the weekly ATR of 17.85. This would have AMZN priced around 221 and we as the sellers of the 220 cash secured put are still not "forced" to buy.

PART I – B

An additional way of interpreting the probability of getting the stock at 220 or below, besides the ATR, would be simply by paying attention to the delta. Delta has many different meanings, but the meaning that we are choosing to focus on is the probability of expiring in the money. Observe the transaction listed below and notice the delta in the brackets. It is positive six because the put was sold; had it been bought then the delta would be negative.

STO – 1 Sep Weekly [+0.06] 220 put @ 0.95

Probability of 220 put expiring OTM is 94%

We can also figure out our breakeven point. BEP = 220-0.95 = 219.05

For the rate of return on the investment, we can simply divide the max profit by the risk per share. For one sold 220 put, we are getting 0.95 cents while 220 per share is being tied up for the duration of the contract. We are receiving 95 and tying up 22,000.

ROR = 0.95/220 = 0.0043

Figure 2 above shows the AMZN option chain with the intention of pointing out the fact that we could select different strike prices. However, no matter which we select, there are a few things simultaneously taking place. The closer the strike price is to the current price, the higher the premium (and the risk) and the lesser the chance of seeing the put expiring worthless. For instance, reading the table below from the right to the left, which is opposite of what Gutenberg printing has conditioned us to do, we already know that the 220 put gives protection of 20 points, has a delta of only six and premium of 0.95. Notice how things change as we decrease the amount of space between the sold strike and the current AMZN price at 239.30; for the 225 put, the protection is (239.3 – 225 = 14.3 + 1.42 of premium) 15.72 which is well within the reach of the weekly ATR. On the 230 put, things are even worse; hence, the names are assigned as Aggressive for the 230 and Moderate for the 225, and Conservative for the 220 put.

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