Today we’ll look at a strategy used by many conservative investors – the cash-secured short put.
Example Cash Secured Put Trade
In the chart below you can see that following a sudden drop, IWM was near a price level from which it had previously rallied strongly. We thought IWM would be a good buy at around $145 to $146.
On that day, put options expiring in three weeks could be sold for $2.07 per share, which is $207 per option contract. The person to whom we sold the put would be paying us $207 in exchange for our taking on the obligation to buy the IWM shares from them for $146 per share if they ordered us to. We were happy to take on this obligation, because we wanted to buy the IWM shares for around $146 anyway. Why not let someone pay us to be willing to do something we wanted to do?
How did this trade stack up in terms of return on investment (ROI)?
Calculating Return on Investment for Cash Secured Puts
The ROI can be calculated in a very similar way to the method used for covered calls.
The Return part of the ROI is the $207 received for selling the put option. In any option trade like this one, where you initiate the trade by selling an option short, your maximum return is the money received for the sale. This money is deposited into your brokerage account immediately when you sell the option.
The Investment part of the ROI calculation is the amount of money you must have on deposit in order to make the trade. In this case, that was $146 per share, or $14,600 total. As we sent the order to sell the put, our broker would check to see if we had this much free cash in our account. If so, then the trade would be allowed to go through. The $14,600 that we might have to pay for the stock was then frozen in our account.
If IWM did not drop below $146 in the three weeks, before the option expiration, then the person who bought the put would have no reason to exercise it. Why sell us the stock for $146 when they could sell it in the open market for more than that? In that case, the option would be allowed to expire. When it did, the $14,600 that had been frozen in our account would be unfrozen and available for another trade. Our profit would be $207 on an investment of $14,600, or 1.42%. This was over a period of 22 days. Annualizing this return, we get 1.42% X 365 days per year / 22 days in the actual trade = 23.5% annualized. This 23.5% would be our Return if Not Assigned.
Note that this is not the only possible outcome. If IWM was below $146 when the options expired, then the put option would be exercised. In that event, our broker would take that $14,600 in cash from our account and put in 100 shares of IWM. Our cost per share would be $146 less the $2.07 we had earlier received (which we had all along). This would be $143.93 per share. This amount would be our cost, and therefore our break-even point. Our actual return in this case would depend on exactly at what price IWM was trading at the expiration date. If it was trading anywhere above our breakeven price of $143.93, then we would have a profit. Otherwise we would have a loss.
Even if we did end up sustaining a loss, it would be a smaller loss than we would have had if we had simply bought IWM when it reached our entry point of $146. Remember, our cost was less than this by the amount received for the put – we had acquired IWM at a discounted price.
Below is the model for the calculation of ROI on a cash-secured short put trade.
Using this model, you can easily evaluate any short put trade opportunity. For long-term investors, selling cash-secured short puts is an effective way to acquire stocks at a discount.
Read the original article here - Option Profit Calculations – Cash Secured Puts