Screening for CSEP Candidates
- Cash-secured equity puts (CSEPs) are a popular options strategy and can be an effective way to acquire a stock you would like to own.
- Find out about a five-step process to search for potential CSEP candidates.
- Hear about the Customizable Options Screener and Schwab Equity Ratings®.
Whenever I talk about the potential benefits of cash-secured equity puts (CSEPs), the question I'm asked most often is, "How do I find good candidates?"
There's no single answer, but let me walk you through the five-step process I've used for many years, which might make your search for quality candidates a little easier.
Step 1: Assess the overall market
As I've written previously, the profit-and-loss characteristics of a CSEP are very similar to those of a buy/write (covered call), and the ideal scenario is one where you are bullish on the underlying stock in the long term, but you are neutral to slightly bearish about the market in the near term. The strategy can still be profitable in a slightly bullish market, or even an extremely bullish market, but there may be less profit potential.
It's also important to look at market volatility because CSEPs typically perform best when volatility is stable or declining. However, when the market is slightly bearish, volatility is often rising. The most common method for gauging market volatility is the CBOE Volatility Index (VIX). You can get quotes using ticker symbol $VIX on any Schwab trading platform. While the VIX measures implied volatility on the S&P 500® index, it's also considered a proxy for market volatility overall.
As you get a read on sentiment and volatility, here are some ways to improve your chances of trading CSEPs profitably.
In a slightly bearish market, it's important that the volatility be relatively high from a historical perspective. Under these circumstances, consider choosing a strike price for your put options that is 5-10% out of the money.
When volatility is relatively high options prices will usually be slightly higher, so out of the money put options should be a little more expensive than during times of lower volatility. This will provide further room for the stock to fall before being assigned, and in a moderately bearish market this is a key consideration. While options that are 5-10% out of the money will have less value than those that are just slightly out of the money, the higher volatility should make the puts valuable enough to make the strategy worthwhile.
By selling options that are significantly out of the money, you greatly reduce your potential profit if the options expire worthless. However, if you are assigned you will end up paying a much lower price for the stock than you might have if you had simply bought the stock outright, and that reduces your downside risk—especially important during a slightly bearish market.
During a flat market in which volatility may be average from a historical perspective, consider choosing a strike price for your put options that is approximately 1-5% out of the money. When volatility is average, options prices will typically be a little lower than during a bearish market and that might cause options that are farther out of the money to be priced so low that the risks involved outweigh the profit potential.
When the market is relatively stable or flat, the downside protection provided by lower-strike puts may be considered less important. By selling just slightly out of the money puts, you not only increase the premium you receive, but you also increase the profit potential if the options ultimately expire worthless.
In a bullish market, when volatility may be below average from a historical perspective, consider choosing a strike price for your put options that is approximately at the money. When volatility is below average, option prices will typically be lower than during a flat or bearish market, so choosing a strike price very close to the money will usually result in a large enough option premium to make the strategy worthwhile.
While at the money options may provide less downside protection than out of the money options, downside protection is usually a much smaller consideration in a bullish market. Additionally, by choosing a strike price that is approximately at the money, you increase your chances of being assigned, but you also increase the option premium you receive the day you sell the puts.
Take a look at the table below, which shows hypothetical examples of how different strike prices and volatilities could affect CSEPs under various market conditions.
CSEPs in Bullish, Flat and Bearish Markets
|Bullish market||Flat market||Bearish market|
|Approximate stock price||$44.05||$44.05||$44.05|
|Approximate put price||1.45||0.80||0.40|
|Debit or credit||Credit||Credit||Credit|
|Maximum gain %||3.3%||1.8%||0.9%|
Source: Schwab Center for Financial Research.
Notice that during a bearish market, when downside protection is a big concern, you would typically select a strike price for your puts that is 5-10% out of the money. In our example, the stock is trading at $44.05 and the proposed strike price of the puts is $40. Since the implied volatility is relatively high at 50%, this trade has a maximum profit of only 0.9% if the puts expire worthless, but it provides a downside hedge of 10.1% if the puts are assigned. (After assignment, all the normal risks of stock ownership begin.)
In other words, while the options would be assigned if the stock dropped below $40 at expiration, you wouldn't incur losses unless the stock fell below $39.60—a drop of more than 10% from the day the puts were sold.
If XYZ stays flat or rises and your puts expire worthless, buying the stock initially at $44.05 would only have been a better trade if XYZ exceeds $44.45 at expiration.
During a flat market, when downside protection is of moderate concern, it usually makes sense to select a strike price for your puts that is 1-5% out of the money. The stock in our example is trading at $44.05 and the strike price of the puts is $42. Since the implied volatility is a little lower at 44%, this trade has a maximum profit of only 1.8% if the puts expire worthless, and it provides a downside hedge of 6.5% if the puts are assigned.
In other words, while the options would be assigned if the stock dropped below $42 at expiration, you wouldn't incur losses unless the stock was below $41.20—a drop of more than 6% from the day you sold the puts.
If XYZ stays flat or rises and your puts expire worthless, buying the stock initially at $44.05 would only have been a better trade if XYZ exceeds $44.85 at expiration.
During a bullish market, downside protection is of less concern, and you would typically select a strike price for your puts that is approximately at the money. In the example, the stock is trading at $44.05 and the strike price of the puts is $44. Since the implied volatility is relatively low at 38%, this trade has a maximum profit of only 3.3% if the puts expire worthless, and it only provides a downside hedge of 3.4% if the puts are assigned.
In other words, while the options would be assigned if the stock dropped below $44 at expiration, you wouldn't incur losses unless the stock was below $42.55—a drop of more than 3% from the day the puts were sold.
If XYZ stays flat or rises and your puts expire worthless, buying the stock initially at $44.05 would only have been a better trade if XYZ exceeds $45.50 at expiration.
Step 2: Look for candidates
Now that you've assessed the mood of the overall market, the next step in identifying good CSEP candidates is to create a screener (or screeners) to help find potential stocks or ETFs. Options-approved clients can do this using Schwab's Customizable Options Screener. While this tool is designed to meet the needs of options traders of all levels, here we'll focus on the parameters most important to CSEPs.
Average volume (underlying criteria)
In my opinion, you should avoid low-volume stocks because illiquid stocks almost always have illiquid options. Consider setting the minimum average daily volume (over the last 20 days) to at least 100,000 to 200,000 shares.
Implied volatility (option criteria)
Put options on stocks whose implied volatility is too high will bring in much larger premiums when sold, but that's because such trades are often excessively risky and generally not worth the modest profits that might be generated. Consider setting this parameter to a maximum implied volatility of 50% in low-volatility markets. In high-volatility markets, you may want to consider going as high as 75%.
Open interest (option criteria)
As a secondary measure to ensure that you don't end up selling options that have low liquidity, I think it's a good idea to set the minimum "Open Interest" value to 500 contracts. This should increase the likelihood that you'll be trading with another individual investor rather than a market maker, and that usually translates into tighter bid/ask spreads and greater size at each quote.
Intrinsic value (option criteria)
The simplest way to isolate at the money and out of the money puts at the same time is to select "All the Money" in the screener but then set the "Intrinsic Value" to "From 0 To 0", since only in the money options have intrinsic value.
Static rate of return (maximum gain)
This is a little trickier. As an active options trader myself, I've always felt that one of the most important measures of the merit of any CSEP is how much profit I'll earn if the stock goes sideways. If you follow the guidelines I've listed above and the CSEPs you sell are always either at the money or out of the money, you may find that you rarely get assigned in a sideways market.
For comparison purposes, however, consider calculating the static rate of return (maximum gain) relative to the underlying stock (as shown in the table above)—in other words, calculate what percentage of the underlying stock price the option premium represents. Here are some realistic guidelines to consider:
|Put option is …||Option premium as % of underlying stock price, minimum guideline|
|At the money||2-4%|
|1-5% out of the money||1-2%|
|5-10% out of the money||0.5-1%|
|Put option is …||Option premium as % of underlying stock price, minimum guideline|
|At the money||3-5%|
|1-5% out of the money||1.5-2.5%|
|5-10% out of the money||1-1.5%|
Unfortunately, if there would be no assignment when the stock moves sideways, the Customizable Options Screener can only measure static rate of return on the actual option being sold. Therefore all CSEPs that are initially at the money or out of the money will show a static rate of return of 100%. While these calculations are accurate for the option itself, they are not particularly useful when setting up the screener.
To help solve this problem, consider setting up multiple screeners for options with specific values on stocks that fall within specifically defined price ranges. The table below shows how to set these parameters in the Customizable Options Screener.
|Underlying price range||Option price|
|From: 10 to 20||From: 0.40|
|From: 20 to 40||From: 0.80|
|From: 40 to 60||From: 1.20|
|From: 60 to 80||From: 1.60|
|From: 80 to 100||From: 2.00|
Once you have created options screeners that have the settings you want (as in the example below) be sure to name them so you can save them for future use. For example, I call this one "20-40 1month CSEP." This particular screen isolates short puts only on stocks priced from $20 to $40 per share.
A Customized Options Screen
Once you get your output screen (example below) you can sort by any of the column headers, obtain detailed quotes of individual options or option chains, and even enter an order directly by clicking on the "Open/Close" buttons.
Source: schwab.com. Stock and option symbols, prices and volume data shown for illustrative purposes only.
Step 3: Check the ratings
After you get your output list from the screener using the process above, consider checking two additional factors before you enter any orders: the Schwab Equity Rating and the Market Edge Second Opinion® Weekly Rating.
I suggest only trading CSEPs on stocks with a Schwab Equity Rating of A or B and a Market Edge rating of Long with a Score of 0 or -1. Both of these ratings are available by clicking on the stock symbol from the output list of your screener. To obtain the Market Edge Score, click the View Research button located just above the Market Edge rating.
Checking the Ratings on an Underlying Stock
Source: schwab.com. Securities shown are provided as an example for illustrative purposes only.
If you are interested, you can read the accompanying Schwab Equity Rating Report located just below the Schwab Equity Rating, which provides detailed information to help you understand the factors that determine the rating. Similarly, Market Edge provides a detailed explanation of their ratings system—click Second Opinion Weekly Quick Start on the Ratings page.
Step 4: Order entry
For a CSEP, as with most strategies, you usually don't have to accept the market bid price for execution. For an option priced in pennies, when the spread is more than a few cents consider entering a limit order between the bid and ask price. To help maximize your chances of getting an execution, but at a favorable price, consider entering the order slightly on the low side of the midpoint.
For an option priced in nickels that has a spread wider than five cents, such as in the example below, consider entering your order in the middle at 3.25.
Entering a Limit Order for a CSEP
Source: StreetSmart Edge®
Once your order is executed, the goal is typically to hold it until expiration. However, if the stock moves higher or lower faster than you expect it to, you may decide that you want to close out your position in the market prior to expiration. Keep in mind however, that you'll never hit your maximum profit unless the option expires worthless, and when that happens, you don't have to pay a commission charge.
Step 5: Check the chart (optional)
If technical analysis is part of your regular trading strategy, be sure to check the chart before you trade. Remember, you should only consider a CSEP on a stock you want to own.
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