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.


In the above put spread scenario, premium income was $60 per contract ($1.00 - $0.40) and the maximum risk was $440 ($95 - $90 = $500 - $60 of net premium income). If the shares remain above $95 by the expiration date, then the option expires worthless and the seller of the put spread locks in a realized gain of $60 or a return on investment of 13.6% ($60/$440). This is the essence of risk-defined options trading where a minimal amount of capital is leveraged and return on investment is maximized.


No matter where the stock moves, losses are capped at $440 per contract even if the underlying stock falls to zero. This is the case due to the protection put leg that was purchased at the $90 strike. In the worst case scenario, if the stock was to fall to zero, you would be assigned shares at $95 and then sell the shares for $90 for a max loss of $5 per share less the $0.60 in premium thus max loss of $440 per contract.


Market Meltdown and Undefined Risk:


January 2022 experienced a dramatic sell-off in stocks and became one of the worst months since the March 2020 Covid lows and one of the worst Januarys on record. Many stocks lost 20%-70% of their market capitalizations over the course of a few weeks. Using the example above with a cash covered put, shares would’ve been assigned at $95 per share and thus would eat up $9,500 of capital. Let’s assume the stock had lost 30% of its value during the market wide sell-off. Given a 30% drop, the shares would be assigned at $95 however they would be trading at $70 on the open market. Resulting in the $9,500 assignment being worth only $7,000 with the $9,500 in capital now tied up in owning the underlying security.


Cash covered puts can not only be dangerous in situations like this but can also tie up substantial amounts of capital with unrealized losses. A risk-defined put spread is essential in order to limit downside risk and avoid any capital-intensive assignment of shares. When comparing the two scenarios, the put spread would result in a max loss of $440 per contract however with a 30% slide in the underlying stock, an unrealized loss of $2,500 per contract would result. This is a five-fold difference in losses when comparing a risk-defined put spread to a cash covered put spread.


10 Rules for an Agile Options Strategy:


A disciplined approach to an agile options-based portfolio is essential to navigate pockets of volatility and circumvent market declines. A slew of protective measures should be deployed if options are used to drive portfolio results. When selling options and managing an options-based portfolio the following rules of options trading are essential (Figure 1):


1) Trade across a wide array of uncorrelated tickers

2) Maximize sector diversity

3) Spread option contracts over various expiration dates

4) Sell options in high implied volatility environments

5) Manage winning trades

6) Use defined-risk trades

7) Maintains a ~50% cash level

8) Maximize the number of trades so the probabilities play out to the expected outcomes

9) Place probability of success in your favor (options delta)

10) Appropriate position sizing/trade allocation

Figure 1 – The importance of risk-defined options trades such as put spreads, call spreads and iron condors which is the foundation of options trading - Trade Notification Service and Options Screening Tool


Conclusion:


An options-based portfolio can provide durability and resiliency to drive portfolio results with substantially less risk via a holistic portfolio approach via options, cash and stock. When engaging in options trading, specific options trading rules must be followed and one of the most important rules is to structure every option trade in a risk-defined (put spreads, call spreads, iron condors, etc.) manner. The market meltdown in January reinforces why appropriate risk management is essential and all option trades should be risk defined. An options-based approach provides a margin of safety while circumventing drastic market moves while containing portfolio volatility.


Hence the importance of risk-defining all options trades to limit any downward stock movement beyond your protection strike. Risk-defined options trading prevents any losses beyond a specific strike price, avoids the assignment of shares, does not require a significant amount of capital and does not potentially result in unrealized losses while tying up large sums of capital with share assignments. Just a simple example between a risk-defined put spread and a cash covered put resulted in a 5-fold magnitude of losses given a 30% drop in a stock which was the norm in the month of January where many stocks were more than cut in half.


Disclosure: Stock Options Dad LLC is a Registered Investment Adviser (RIA) firm specializing in options-based services and education. There are no business relationships with any companies mentioned in this article. This article reflects the opinions of the RIA. Any recommendation contained in this article is subject to change at any time. No recommendation is intended to constitute an entire portfolio. The author encourages all investors to conduct their own research and due diligence prior to investing or taking any actions in options trading. Please feel free to comment and provide feedback, the author values all responses. The author is the founder and Managing Member of Stock Options Dad LLC – A Registered Investment Adviser (RIA) firm www.stockoptionsdad.com defining risk, leveraging a minimal amount of capital and maximizing return on investment. For more engaging, short duration options-based content, visit Stock Options Dad LLC’s YouTube channel. Please direct all inquires to info@stockoptionsdad.com. The author holds shares of AAPL, ADBE, AMZN, AXP, BA, BBY, BMY, C, CMG, CRM, DIA, DIS, FB, FDX, FXI, GOOGL, GS, HD, INTC, IWM, JPM, MRK, MSFT, NKE, NVDA, PYPL, QQQ, SPY, SQ, TWTR, UNH, USO, V and WMT.


Originally published in agreement with INO.com

https://www.ino.com/blog/2022/02/downside-protection-risk-defined-put-spreads-vs-cash-covered-puts/#.YgSbaOrMJPY

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