Downside Protection: Risk-Defined Put Spreads vs Cash Covered Puts

Introduction:


Options trading can provide a meaningful addition to one’s overall portfolio strategy when used in a disciplined manner. When options are used as a component to a holistic portfolio approach, generating consistent monthly income while defining risk, leveraging a minimal amount of capital and maximizing returns is achievable. An options-based portfolio can provide durability and resiliency to drive portfolio results with substantially less risk via a combination of options, long equity and cash. When engaging in options trading, specific rules of options trading must be followed. One of the most important rules is to structure every option trade in a risk-defined (put spreads, call spreads, iron condors, diagonal spreads, etc.) manner.


The January 2022 meltdown in the overall markets is a harsh reminder of the trade-offs between risk-defined options and options that have undefined risk. The overall markets were in freefall with a large percentage of stocks getting cut in half with indiscriminate selling across all sectors. The extreme market conditions throughout the month of January resulted in all stocks auto-correlating in a downward spiral. During these periods of relentless selling across the markets, risk-defined options are essential to protect one’s portfolio from massive losses while preserving cash on-hand within the portfolio.


Put Spreads vs Cash Covered Puts:

Risk-defined option spreads (i.e. put spreads) prevent any losses beyond a specific strike price, avoids the assignment of shares, does not require a significant amount of capital and does not soak up capital with share assignments. Conversely, in the case of cash covered options (i.e. cash covered puts), large amounts of capital are dedicated to the trade and share assignment may occur at your strike price with substantial downside risk. Undefined option trades also eat up cash on-hand via assignment that could be tied up in an assigned stock position far below your strike price. This assignment may be sitting in your portfolio with substantial unrealized losses while reducing your portfolio’s cash liquidity.


Risk-Defined Options Trading:


Risk-defined option trades are explained below using a theoretical example deploying a put spread on a stock that currently trades at $100 per share.


1) Sell a put at a $95 strike and collect $1 per share in premium – You take on the obligation to buy shares for $95 by the expiration date and receive $100 in option premium income.


2) Buy a put at a strike of $90 by using some of the premium received (e.g. $0.40 per share) – You have the right to sell shares at $90 a share by the expiration date.