Here are some notes I took from the book “Selling Cash-Secured Puts” by Alan Ellman. I’m already familiar with how options work and have read his book on covered call writing. These notes only cover the new concepts I learned. I strongly recommend that you buy both books (both are excellent) for more details and information.
Chapter 4: Selecting the Best Strike Price and Expiration Date for Put Selling
Defining our goals
Stock acquisition at a discount
- Cost of Acquisition = Strike Price – Premium Collected
- If unexercised, return = premium/cost * 100%
- Target 2% to 4% return per month
- If bearish, target lower end of the range and sell deeper OTM strikes (e.g. 1 to 2 strikes deep)
- If bullish, target higher end of the range and sell near the money strikes
Income Generation Only
- Sell OTM put
- OTM put gives us lower return but reduces the chance of being assigned
Combining Put Selling with Covered Call Writing
- Sell OTM put
- If exercised, sell covered call
General Market Considerations for Strike Price Selection
If bearish, better to select deep OTM strikes.
To assess overall market tone, look at the 6 month S&P500 chart, 6 month CBOE VIX chart, and weekly economic reports.
We want the S&P 500 chart to be uptrending with 50D EMA > 200D EMA and VIX to be declining or stabilizing below 20.
Weekly reports include: Beige book, Business Inventories, Capacity Utilization Rate, Construction Spending, Consumer Confidence, Consumer Credit, Consumer Price Index, Durable Goods Orders, Employment Cost Index, Employment Situation, Existing Home Sales, Factory Orders, FOMC Meetings, GDP, Industrial Production, Initial Jobless Claim, ISM index, ISM non-manufacturing index, Leading Economic Indicators, New Home Sales, New Residential Construction, Non Farm Payrolls, Personal Income, Personal Spending, PPI, Retail Sales, U.S. Trade Balance etc.
Chapter 5: Calculating Put Option Returns
Formulas
If put is not assigned
ROO = \frac{premium}{strike - premium}If put is assigned
Cost of Stock = Strike – Premium
Breakeven = Strike – Premium
If position is closed mid contract
ROO = \frac{premium - \text{cost to close}}{strike - premium}ROO Target
Bullish: 2% to 4% per month
Bearish: 1% to 2% per month
Chapter 7: Portfolio Management
We need three lists to manage and keep track of our portfolio:
- watchlist of eligible stocks
- list of open positions
- list of closed positions showing profits/losses
Chapter 8: Exit Strategies
Refer to https://smarttradingstrategies.com/covered-call-writing-notes-part-3/ for the definitions of the three zones.
| Zone | Steps |
| Orange | If stock appreciates above strike price Buy back option when its value <= 0.2*original premium If stock is less than 3% below strike price Do nothing but monitor. The loss incurred (strike price – current share price) should be less than the option premium. If stock is more than 3% below strike price If the stock is weak (i.e. underperforming the market) or the market is weak and unlikely to recover, buy back the option at a loss. If stock gaps down significantly If the gap down is due to a serious issue (e.g. fraud investigation by SEC), buy back the option. Else, get assigned and sell OTM calls (but avoid selling during earnings months) |
| Blue | Buy back the option if premium <= 0.1*original premium |
| Black | If the option is ITM and you do not want assignment – If there is no upcoming earnings, roll out to the next month (same strike price) for a credit. – Else, buy back the option (should not be too expensive now). If the option is ITM and you want assignment Buy the stock and sell a covered call if there is no upcoming earnings report If option is OTM Let it expire worthless |
Chapter 9: Exchange Traded Funds
- Need not be concerned with earning reports
- However, ETFs have lower implied volatility and hence lower premium and returns (target 1% to 2% per month)
Criteria
- Outperform S&P500 over past 3 months
- RS ratings of 60 or better
- Average daily volume of at least 250k shares (3 month average)
- Open interest of 100 contracts or more for near the money strikes
- Not a leveraged fund
Free sites for ETF screening
- Wall Street Journal
https://online.wsj.com/public/quotes/etf_screener.html - Market Watch
https://www.marketwatch.com/tools/etfs/html-adv-screener.asp - Morningstar (need to create account for free)
https://screen.morningstar.com/etfselector/etf_screener_version1.aspx
Select Sector Spiders
Select sector spiders (SPDRs) are unique ETFs that divide the S&P 500 into nine sector index funds. You can compare the relative performance of the funds and select the top 3 performing funds. The nine sector funds are
- XLY (Consumer Discretionary)
- XLP (Consumer Staples)
- XLE (Energy)
- XLF (Financial)
- XLV (Health Care)
- XLI (Industrial)
- XLB (Materials)
- XLK (Technology)
- XLU (Utilities)
Inverse ETFs
Inverse ETFs (e.g. PSQ, DOG, SH, RWM) rise when market falls. Best utilized in strong bear markets rather than when there are minor corrections.
Implied Volatility
Implied volatility is the forecast of the underlying security’s volatility as implied by an option’s price.
Can be interpreted as the anticipated % change in either direction in one year.
For instance, if IV = 33, the market is anticipating a 33% price change in the underlying security in either direction.
Chapter 15: CCW vs CSP
| Covered Call Writing | Cash Secured Puts |
| – Capture dividends – Max profit = Premium + Share Appreciation – Slightly bearish to bullish outlook – Must buy shares first – Early assignment is not an issue | – No dividends, but premium tends to be higher when there is a dividend distribution – Slightly bearish to neutral outlook – Must deposit cash first – Early assignment may be a problem when the stock crashes rapidly |
Chapter 16: The Put-Call-Put Strategy
Suitable when you are bearish on the overall market or have a very low risk tolerance and do not want to pay full price for the shares before writing call options
Steps:
- Sell OTM puts
- If exercised, sell call option on this “discounter” stock
For step 1, we favour OTM puts in all market environments and go deeper OTM in extremely bearish market environments
For step 2, we favour ITM strikes in bear markets and OTM strikes in bull markets
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