The Importance of the 3% Guideline When Selling Out-Of-The-Money Cash-Secured Puts – February 26, 2024
On 10/20/2023, a member shared with me a cash-secured put series of trades executed with Charles Shwab Corp. (NYSE: SCHW). Over the course of 9 months, SCHW dropped in price from approximately $83.00 to $50.87. This series of trades started by selling out-of-the-money (OTM) cash-secured puts which were exercised. The next 7 months involved writing (OTM) covered calls to help mitigate the severe share price decline. I was asked to analyze the trades and if continuing to write OTM covered calls was a viable solution to this losing scenario.
Overview of the SCHW trades
- 1/13/2023: STO 2 x 3/17/2023 OTM $80.00 puts with SCHW trading at about $84.00
- 3/17/2023: SCHW trading at approximately $57.50
- 2 x $80.00 puts were exercised, and shares purchased at $80.00
- Over the next 7 months OTM covered calls were sold on SCHW
- On 10/20/2023, SCHW was trading at $50.87
Price chart summary of the SCHW trades
What is the BCI 3% guideline as it relates to selling OTM cash-secured puts?
If share price drops 3% or more below the OTM put strike, we close the put position and avoid the pain of further price decline. Of course, share price can recover, but do we want to take the chance on a security already under-performing our expectations? I submit, no. In the case of the original SCHW put trade, the threshold to close the put trade was $77.60 (3% below $80.00). This price point is 8.8% below the original price of the security ($84.00) when the put trade was initiated. Time to protect ourselves (aka bail).
A picture is worth 100 words: Comparison chart of SCHW versus the S&P 500
Of course, we are all much smarter looking back, but the graphic shows the type of scenario the BCI 3% guideline protects us from. Will this or any exit strategy benefit us 100% of the time? No, nothing works 100% of the time. However, it will protect us from catastrophic losses.
Discussion
The BCI 3% guideline is an excellent tool in mitigating substantial share price decline when selling OTM cash-secured puts. A plan must be in place prior to entering every trade, as how to take advantage of all exit strategy opportunities, whether it’s to mitigate losses or enhance gains.
Author: Alan Ellman