Cash Covered Put Options

Part 12 Options Trading Using Cash Covered Puts

Sometimes I enter a buy limit order at a price I want to pay for a stock, but the stock never seems to drop to my price. While I am waiting, I would like to earn some additional income. This is possible using a cash-covered put option.

When you want to buy a stock, there are at least three courses of action you can take. 1) You could enter a market buy order and pay the current price for the shares. 2) You could enter a buy limit order at a price lower than the current price. 3) You can sell a cash covered put and receive income from the buyer of your put.

“By selling a cash-covered put, you can collect money (the premium) from the option buyer. The buyer pays this premium for the right to sell you shares of stock, any time before expiration, at the strike price. The premium you receive allows you to lower your overall purchase price if you get assigned the shares.” – Fidelity Investments

If, however, the price never drops to your contract price, you won’t buy the shares and you keep the premium you received for selling the put. One of the problems with this approach is that every put option requires you to be ready to buy 100 shares at the put price. Therefore, if you want to buy the shares for $80, you must have $8,000 of cash in your account reserved to buy the shares if the contract price is reached. This is how the put is “covered.”

There is another “problem” with this approach. The dollars that cover your put cannot be used for something else. You have locked up that piece of cash until the contract expires. Remember, however, that you could have just purchased the shares instead of selling the put, which would have used up the cash anyway.

You Can Roll Puts

In the same way that you can roll covered calls, you can roll puts. This is more powerful when the price of the shares is rising. Let’s say, for example, that you sold a put for shares with a contract price of $85. If the shares rise to $86, it is very likely that you can roll the put and receive additional premium income. That is what I am doing with SQM.

SQM Business Profile

SQM has been paying some big dividends. But don’t count on this going forward.

In a day when lithium battery components are increasing in demand, I am interested in lithium mining companies. One of the stocks I have started to buy is SQM. This is not without risk. SQM is located in a country that has political uncertainty. What follows is a full summary of the business.

Sociedad Química y Minera de Chile S.A. produces and distributes specialty plant nutrients, iodine and its derivatives, lithium and its derivatives, potassium chloride and sulfate, industrial chemicals, and other products and services. The company offers specialty plant nutrients, including potassium nitrate, sodium nitrate, sodium potassium nitrate, specialty blends, and other specialty fertilizers. It also provides iodine and its derivatives for use in medical, pharmaceutical, agricultural, and industrial applications comprising x-ray contrast media, polarizing films for LCD and LED, antiseptics, biocides and disinfectants, pharmaceutical synthesis, electronics, pigments, and dye components. In addition, the company offers lithium carbonates for various applications that include electrochemical materials for batteries, frits for the ceramic and enamel industries, heat-resistant glass, air conditioning chemicals, continuous casting powder for steel extrusion, primary aluminum smelting process, pharmaceuticals, and lithium derivatives, as well as ingredient in manufacturing of gunpowder. Further, it supplies lithium hydroxide for the lubricating greases industry, as well as cathodes for batteries. Additionally, it offers potassium chloride and potassium sulfate for various crops, including corn, rice, sugar, soybean, and wheat; industrial chemicals, including sodium nitrate, potassium nitrate, potassium chloride, and solar salts; and other fertilizers and blends. The company operates in Chile, Latin America and the Caribbean, Europe, North America, Asia, and internationally. Sociedad Química y Minera de Chile S.A. was incorporated in 1968 and is headquartered in Santiago, Chile.

SQM’s Equity Summary Score and Important Dates

As with covered calls, always check the earnings date and ex-dividend date. You want to make informed decisions because those dates can impact the price of the shares. When I first sold the cash covered put for SQM, the prices for the shares were above $85. I received $189.32 for the put with shares priced at $90 in December. Later in December I rolled the put contract to $85 because the market was falling. This cost me $1.36. That is a small price to pay to lower my total potential cost. My most recent trade extended the contract from January 20 to February 17 keeping the contract price at $85. I made $213.64 for that roll. So, as you can see, I have received over $400 using this approach with SQM since early December of last year.

Always know the Earnings Date and the Ex-Dividend date.

Rolling the January 20 Put to April 21

It is possible to make $3.00 per share, or $300 by rolling out to a future date. But be careful what future date you select. Remember, you must have cash ready to cover the put option.

This illustrates extending the contract date and lowering the put price from $85 to $80.
If I get a buyer, I will receive about $298.70 as a premium. But I am tying up my $8,000 cash for several months. Is that wise? I don’t think so.

Rolling the January 20 Put to February 17

Because the February date is not as distant, the dollar amount for the contract shrinks to $2.00 in this example.

This contract makes more sense for a roll. I am only extending it for one month with the same contract price.
Of course, the amount of the premium is less because the contract has a shorter duration.

It is possible to play with the contract price. Sometimes you can still entice a buyer with a contract that will earn you a bit more income. You can also lower the contract from $85 to $80, if you think the stock might decline in price. You will usually have to pay a bit to make that happen. In this case, it would be $0.15 per share, or $15.00.

The closer you get to the current date, the more expensive it will be to roll a put that is currently at $85, but you think you want to move to the $80 contract price. In general, I don’t think that is prudent. Why pay more for something that might not happen? If you thought $85 was a good price for a long-term holding, don’t roll the put.

Here is a trade that makes more sense. Buy to close the $85 put and sell to open a new cash covered put to replace it at $85 per share. This keeps you cash requirement the same and gives you some additional income.

This was the actual contract Roll I entered and the order worked. I received $213.64 after the commission and fee.

Summary

The goal of this post was to illustrate another way to generate income trading options. The two primary methods I use are selling covered call options, and cash covered puts. Most of my trades are call options because I don’t like to have too much cash sitting idle. However, when I am interested in buying an investment, there is a place for selling cash covered puts.

Links for Learning

Learn more about cash covered puts at Fidelity Investments. FIDELITY LINK