Selling Cash-Secured Puts Exit Strategies: The 3% Guideline: A Real-Life Example with NVIDIA Corp. (Nasdaq: NVDA) – December 20, 2021
When we sell cash-secured puts, we must use all 3 of our required skills: stock (or ETF) selection, option selection and position management. Once we have selected an elite-performing security, we then choose an out-of-the-money (OTM) put strike that meets our initial time-value return goal range (2% – 4% per-month, for me). Without exit strategies, our maximum return is the put premium and that profit is realized as long as share price does not decline below the OTM put strike. But what do we do if share value does decline below that put strike despite our rigorous screening process? Enter our 3% guideline for selling cash-secured puts.
What is the 3% guideline?
This guideline gives us a parameter that assists us in determining when to close our short put position should share value decline significantly. When share value drops more than 3% below the OTM put strike, we should consider closing the short put position. Most of the time, this will result in a trade loss. The cash used to secure that original put trade can then be used to initiate a new put sale, in the same contract cycle, with a different underlying to recover some or all of those losses.
Real-life example with NVDA
- 8/20/2021: NVDA trading at $208.16
- 8/20/2021: STO the 9/24/2021 $200.00 put at $5.65
- What is the trade status if NVDA drops 3% below the $200.00 strike to $194.00, a decline of $14.16 per-share?
BCI Elite Put-Selling Calculator
What is our loss if NVDA drops below the $194.00 3% guideline price point?
Is it $0.35 per-share ($194.35 BE – $194.00 put strike)?
If the shares are put to us at the put strike of $200.00 and NVDA is trading at $194.00, we are losing $0.35 per-share.
Is it greater than $0.35 per-share?
If we are forced to close the short put due to breach of the 3% threshold, we will be losing more than $0.35 per-share. This is because we have to spend money to close the short put (buy-to-close or BTC). That loss will be represented by the following formula:
[$5.95 – (cost-to-close the short put)]
There are 2 Greek factors at work that will determine the CTC the short put:
- Delta: Share decline increases the value of the put making it more expensive to buy back
- Theta: As time progresses, the time-value erosion effect of Theta will cause put value to decline
Overall, we should expect the CTC to be greater than the initial put premium resulting in a trade loss.
Discussion
The 3% guideline is used to mitigate losses and potential greater losses. In the case of NVDA, if share price drops from $208.16 to $194.00 (3% guideline), we have a problem and must take action. The spreadsheet shows the BE price point to be $194.35 resulting in a loss of $0.35 per-share if shares are “put” to us at $194.00. This represents the (put strike – put premium). This stat does not include any exit strategy executions. If we bought back the put option as share price declined, the loss would be ($5.65 – cost-to-close the $200.00 put). This would result in a loss greater than $0.35 per-share but would also mitigate additional losses on a security that has declined in value substantially in this hypothetical. Not all trades will be winners. Our job, as CEOs of our own money, is to mitigate losses and enhance gains.
Author: Alan Ellman