While we have discussed this strategy a bit last April, I want to revisit it today as I feel it can be relevant to the current market.

Perhaps the market has gone a bit higher than you would have liked for it to go.  Yes, you got a profit on your short put option (or you got called away on your stock), but you missed some of the rally as your short premium had limited your profit potential.  Now, it is time to get back into another short put and you are concerned that the market has gone a bit too high for your taste.

The first thing to consider would be to sell a call spread instead of a covered call in the initial trade.  It is discussed in this blog under “Covered Call 2.0”.  However, there are stocks where it makes more sense to simply sell a covered call (or short put) and not have the upside long call.  That is what we will address today.

If you think the stock could pull back a bit, you could consider a ratio put spread.  Let’s go over how it could work. 

1.  XYZ stock is trading at 50/share
2. You can buy 1 45 put for $2/contract
3. You can then sell 2 40 puts for $1/contract giving the trade an even money cost with a risk of anything below 35

How is the risk below 35?  First off, all of these examples assume you will hold the trade until expiration.  Also, commissions are not factored into these costs.  It is for sake of simplicity.  Since it is a 0 cost trade, the 45/40 put spread would have to be worth $5 at expiration.  The one other short 40 put would be the obligation of buying the stock.  Since we have $5 coming from the put spread, it is just like being paid $5 to buy the stock at $40.  After subtracting $5 from 40, you get 35.

The trade would be profitable if the stock expires anywhere between 35 and 45.  Of course the closer to 40 it expires (on either side), the more profitable it will be.

The final thing to consider when doing a trade like this is if you would be comfortable owning the stock if it were assigned.  If the answer is no, then you should use a different strategy.  If the answer is yes, then this could be a great way to get paid to buy a stock you would have wanted to own anyway. 

I like it as it wouldn’t cost you anything except commissions if the stock did continue to go higher.  Should it go lower, there is a potential profit zone to participate.  If it were to go below 35, then I would consider it a plus as I liked the stock at 50, I would love it at 35.

Each person and situation is different.  Consult with a professional before doing a trade like this.

If you are interested in what I do for my clients as a financial advisor, please email me at mtosaw@rcmfs.com.