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Your Price Is Way Too High: You Need to CUT IT

Montréal Exchange
November 24, 2020
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8 minutes read
Your Price Is Way Too High: You Need to CUT IT

Consumers just don’t want to pay full price for anything. There’s always a better deal somewhere out there, or an annual sale just around the corner. As a disciplined consumer, you know how to put the items that you like on your “Wish List” and patiently wait for a sale. This approach can be applied to trading as well. You shop for a stock and look at the price tag. If it seems too frothy, you create an alert, add it to your watchlist and wait for a pullback…in the same way that shoppers wait for a sale. In this article, I’ll show you an option strategy that will pay you while you wait to buy that stock you want!

This option strategy is called “cash secured put writing,” or CSP. In a cash secured put strategy, you need to have the cash required to buy that stock you want (or you could buy it on margin). Just like when you’re shopping, you need to either have the money in your bank account or use credit.

WARNING: Before diving into this strategy, you’ll need to verify with your broker whether you’re authorized to write put options. In addition, this strategy can only be implemented in a non-registered account, due to the income tax regulations on deferred income plans.

How to set up a CSP strategy:
Step 1: Identify a stock that you would like to purchase.
Step 2: Decide on the entry point.
Step 3: Pull up the stock’s option chain.
Step 4: Write a put option on the stock.

How to select a strike price
Writing put options: You’ll receive the option premium in exchange for assuming the obligation to buy the stock at the strike price. Therefore, you need to pick a strike price at which you’ll be OK with buying the stock.

How to select the expiration
As an option writer, you’re selling time. Time decay is your friend, and the option’s time value will depreciate faster as its expiration approaches. So, you have these two benefits working in your favour.

To select the option’s expiration, you need to consider how much premium you’ll collect. For example, you could receive $20 per contract for a 30-day put option. Another investor might be OK with this, but if you want more, you can look at options with longer expirations. Selecting an expiration comes down to deciding what you feel is acceptable.

 

Objective of a CSP strategy
Your goal is not to pay the full retail price on the stock you want. You want to be assigned and buy the stock at a price below today’s market price. Whether or not the put is assigned, all outcomes are presumably acceptable. The premium will improve the net result under any scenario.

Only in-the-money put options will be exercised on expiration

Put’s strike price > Stock price

If this happens, then the shares will be put to you and you’ll have to buy them at the strike price. But there’s a bonus: although you paid the strike price for the stock, your “effective purchase price” is actually lower than that.

 

Understanding your effective purchase price (EPP)
Since you received an option premium for selling the put, your EPP will be:
Strike price – Premium received

This sounds too good to be true. Where is the risk in a CSP strategy?

  1. Extreme gap down. The stock might not just dip a bit, but rather drop well below the strike price. You have to be comfortable with your newly acquired stock.
  2. Extreme gap up. You may wait for a price dip that never comes and miss out on the opportunity to buy the stock. If this happens, you can rinse and repeat this strategy.

Example of a CSP:

Thinking process Cash balance
Cash in the account You want to find a good stock and put your money to work. $6,000
ABC Inc. @ $48
(52-week high)
You’ve found ABC Inc. and you have enough cash to buy 100 shares of it.

 

You don’t want to pay the 52-week high price, you’d rather pay $45/share

 

Instead of placing a buy limit order for $45 GTC*, you use a CSP

CSP You sell a 60-day $45 Put @ $2.10 +$210 ($2.10x100x1)

*Good til cancel

 What just happened: By implementing the CSP, you immediately earned an additional $210 by writing a put option and assuming the obligation to buy ABC Inc. for $45.

Note: You’ll be able to buy the stock only if the option gets assigned. You’ll need to keep sufficient funds on hand, in case you have to buy the shares.

Potential scenarios at expiration:

ABC Inc. < $45:

The put option is in the money, the shares will be put to you at $45 (strike price). Your net purchase price will be $42.90 ($45 – $2.10). In this scenario, you’re able to buy the stock without paying the full retail price.

ABC Inc. > $45:

The put option is out of the money. Although you didn’t get to buy the stock, the extra $210 of premium you collected is better than nothing. Now, you have $6,210 in your account.

The moral of this article is that no one likes to overpay. If you are eager or extremely bullish on a stock, then a CSP isn’t the right strategy. CSP investors are indifferent about whether they’re able to buy the stock or not. If their put option gets assigned, they’ll be happy to own the stock, and if they can’t obtain the shares, then they’ll be equally happy with the option premium received. So the next time you see a stock price that’s way too high, you’ll know what your options are to cut it!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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