How does getting paid to potentially buy a stock at a discounted price sound? How does selling something you don’t own and collecting a cash premium sound?
The answer to these questions might just be the Cash-Secured Equity Put, or CSEP. The CSEP is an income-generating, discount-buying strategy that option traders have been utilizing for years. It is very similar to an options trading strategy that you may already be familiar with, selling covered calls against long stock in your portfolio. Just like covered calls, this is a relatively conservative option strategy where the gains are limited and the risks can be substantial if your stock dramatically falls in price.
Selling a CSEP has essentially the same risk/reward characteristics of the covered call and may provide the same type of income streams and returns as covered calls. Therefore, like the covered call, this is a bullish strategy typically meant for bullish to sideways-trending stocks and equity markets.
So what is a CSEP and how does it work?
A CSEP is an options strategy where you sell a put option at the strike price of your choice and get paid a cash premium for the transaction. In exchange for that cash premium, you take on the obligation to buy shares of the underlying stock (100 shares for every standard put contract) at the designated strike price should the stock close below the strike price at expiration.
Please be aware that equity options can potentially be assigned at any time prior to expiration. The cash-secured component of the trade, where CSEP gets its name from, dictates that the funds required to purchase the shares at the strike price would be held and unavailable to trade until the position is closed or expires.
Let’s look at an example. Stock XYZ is currently trading at $73.00 with 30 days to go until expiration. If you sell 1 XYZ put option contract for $2.25 per contract at the $70.00 strike price, then Schwab will segregate the cash required to buy 100 shares of XYZ at $70.00, which equates to $7,000.00. In exchange for your obligation to buy those 100 shares at $70.00 per share, you are paid an upfront cash premium, from the option buyer in this transaction, of $2.25 per contract, or $225.00 total dollars (each option contract equates to 100 shares).
The maximum at risk in this trade is the $7,000 secured minus the $225.00 premium you received, or $6,775.00. So if you haven’t already figured this out, employing this strategy could result in potential assignment and eventual stock ownership; therefore, utilizing a rule-based strategy for stock selection and option strike selection can be beneficial.
Some of those rules are discussed below, and it is imperative that you consider Rule #1 when entering this type of strategy:
Rule #1: Be willing to own the stock at that predetermined strike price
You could make a case this should be Rule 1, 2, 3, and 4! You might be able to buy the stock at a discount, and get paid to do so, if it settles below your short strike at expiration. That sounds like a great opportunity until it doesn’t. When would that occur? If the stock sells off dramatically and is now below your strike price. Do you still want to own it? This is an important question to ask yourself and could be the difference between you choosing to implement this strategy or not
Rule #2: Assess if the company is fundamentally sound and trading at an attractive price
Stock fundamentals are important because you may end up owning the shares. Consider utilizing schwab.com as a resource for your fundamental analysis. The Schwab Equity Rating is a great source and starting point. Look at the Ratings Summary section to find what other analysts are saying about your stock. Analyze the ratios, especially versus sector peers.
Some of the fundamental indicators and ratios to consider could be Earnings Growth, Price to Earnings, Price to Sales, PEG Ratio, Price to Cash Flow, and Return on Equity. These indicators can help you determine if your stock is undervalued and potentially primed for outperformance. Basically, do your homework. You can use this information to help decide whether you are willing to own these shares or not.
Rule #3: Keep an eye on important technical support levels and trends
Identify short and long-term support levels. These levels are where buyers have stepped up in the past to provide a possible bottom for the stock and could potentially be a good area to consider selling the CSEP. In many instances, this might be a moving average. In the example below, look how the stock has bounced off of its 50-Day Moving Average () on several occasions during its recent uptrend and how the moving average has acted as support.
As always, there are no guarantees, but this could be a good starting point. Also, be mindful of the overall market trend and sector trend, as well. Finding good candidates for the CSEP strategy can be difficult if the overall market and sector trends are bearish.
Source: StreetSmart Edge®
Rule #4 Choose the right expiration month and strike price
The CSEP strategy involves selling a put option which is subject to time decay, so the closer to expiration, the faster the time decay. If you want to take advantage of the accelerated time decay, a good frame of reference would be 20 to 50 days prior to expiration. This is a consideration, but you can always examine the various put series to determine the time frame that best fits your own forecasts.
Why might not sell a closer time frame? Unless there is an upcoming earnings announcement or some other important upcoming event, once you get under the 20 day mark, the premium received usually doesn’t cover the risk taken, but you can make that determination yourself by checking those short-dated contracts in the option chain.
You want to maximize the premium you receive relative to the time you hold the obligation to buy the shares. Determine your strike price based upon a price level that you are willing to purchase the shares if assigned. You could also choose your strike price based off a technical level of support, and the option’s delta could be a good frame of reference as well.
Consider looking for put options with deltas between -0.25 and -0.50. In the example below, you can see there are 44 days to expiration and the strike prices have deltas ranging from -0.29 to -0.46. Generally, the more “aggressive” you are, the closer the delta will be to -0.50. The less aggressive you are, the closer the delta will be to -0.25.
Source: StreetSmart Edge®