When It Comes To Cash Secured Puts, Timing Matters

When used properly, options are not a way to gamble or speculate. Rather, they become conservative tools investors can use to outperform the markets. Covered calls are perhaps the leading example. We would like to highlight another options trade, with many common features.

Cash secured puts give an investor a credit and commit them to buying a stock before the options expiration at a predetermined price. Covered calls allow you to lower your overall cost basis because the premium you receive can be deducted from your original cost basis. Cash secured puts allow your cost basis to be lowered if you are assigned the stock. Covered calls are the more conservative of the two, simply because you already own the stock, whereas cash secured puts obligate you to buy the stock at a predetermined price (the strike) if the option is assigned to you. And that is why timing matters.

Say that you sell a put on Company X at $10 (the stock is currently trading at $12), and it expires in a month. You like Company X, and think thay business is doing fine. But then the company reports its quarterly results and they are not good. There is a slowdown across many geographies, and management cut guidance. The stock promptly falls to $9, and you are forced to buy the stock at $10. While the premium you received, which is yours to keep, offsets some of the loss you now have, it does not cover all of it. And the stock keeps falling as earnings are digested. This scenario illustrates why timing is important with cash-secured puts.

Because you are agreeing to buy the stock at a predetermined price before expiration, it is important to be able to estimate with some certainty how far it will fall by then. Therefore, it is best to sell puts on stocks that have recently reported earnings, so there are no surprises that may send the stock falling.

We are currently in just such a trade with shares of NVIDIA (NVDA). NVIDIA reported its earnings on May 11, and the market liked what it heard, as the company offered bullish commentary on future demand and raised guidance. The company's recent analyst day was also well-received by Wall Street.

We own shares of NVIDIA outright, and would like to buy more. With the stock currently trading at $12.06 (as of this writing), we sold $11 June puts. While we think it is unlikely that the markets will deteriorate so rapidly as to send NVIDIA down to $11 by the expiration date, should such an event occur, we would welcome it.

We know NVIDIA is bullish on its future, and that confidence is reflected in its guidance. Should we be forced to buy more shares of NVIDIA at $11, we would know that the share price is lower not because of a change in the company's fundamentals, but because of poor market conditions.

This is why timing matters with cash secured puts. Investors should only sell them after a company has reported its most recent quarterly earnings, because it is essential to have an up-to-date picture of a company's fundamentals before selling puts against it.