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 Stock Option Strategy - Cash Funded Put

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Cash-funded put strategy description: Writing (selling short) a put option contract and depositing cash funds in case assignment occurs and the trader needs to buy the underlying security.

Strategy's forecast for the financial instrument is neutral to bullish in the short-term. It would lose value through time decay, and eventually if the contract not assigned, at expiration will be worthless (out-of-the-money). This strategy requires depositing the money in the purpose of gaining a favorable interest rate by the strategy's period.

Before entering a trade, please check account requirement and restrictions (see the following note).

Prospect direction: The stock will be neutral or even bullish, considering the duration advantage and implied volatility disadvantage (if the financial instrument declines, normally IV will increase).

Profit potential: At expiration, the premium.

Loss potential: The financial instrument’s price could decline to zero and not below, creating a low boundary to the losses.

Risk / reward: Premium received, divided by probable loss.

Breakeven points:  At expiration strike - premium = stock price.

Time factor: All other variables unchanged, an option typically loses time value premium with every passing day, and the rate of time value loses tends to accelerate as it reaches to the end of its term, the expiration date. As with most short-option strategies, the passage of time has a positive impact on the short seller. As time remaining to expiration decreases the statistical chances for a loss in intrinsic value shrinks, too.

Implied volatility: An increase in implied volatility would negatively affect this strategy, all other variables being equal. Volatility tends to boost the value of an option, because it indicates a greater statistical probability that the stock will move enough to give the option intrinsic value by the expiration day. On the other hand, a decline in volatility has a tendency to lower an option’s value, regardless of the overall stock price trend.

Dividends: The dividend affects negatively the cash-funded put strategy. On an ex-dividend date, the amount of the dividend will deduct from the value of the underlying stock. Although the effect is foreseeable and usually factored more gradually, dividend dates are still a consideration in deciding when it might be optimal to write a put option contract.

Assignment: There is a chance that the option contract holder will assign his or her contract before expiration because the option contract holder has up until the expiration day the right to assign his or her in-the-money contract, or else the contract will settle with cash.

The assignment is sometimes in favor of the contract writer because of the pre-concession of the contract’s holder on the remaining time value to expiration. On the other hand, sometimes assignment is not in favor because of its dependency on fees and slippage.

Assignment process: As the assignment notice arrives at the clearinghouse, the settlement price sets on the assignment day's closing price. At this price, the contract writer will buy the underlying security then the clearinghouse will position the writer by the same amount and price, long underlying security.
The next day the writer will be in a long underlying position and the contract’s owner will be in short position.

Mark-to-Market Profit and Loss
Let us assume an assignment of 10 contracts at strike $45.00 and underlying security at price of $43.00.

• Contract owners account after the assignment: '10 X 100 X 45' (100 deltas or number of stocks for every contract).
• Short position assignment price is $45,000.
• Current position market price is $43,000.
• Mark-to-market profit and loss is: $2,000 profit.

If prior to the assignment the account was long 1,000 underlying securities, then the account will be with no stock and remaining cash of $2, 000, or else the account position is short 1,000 underlying securities.

If the contract holder does not wish to be in the short position or does not have sufficient margin funds, then the contract owner must buy the underlying securities back in the market.

At this point, the contract owner is exposed to market price fluctuations.

• Contract writer account after the assignment: '10 X 100 X 45' (100 deltas or number of stocks for every contract).
• Long position assignment price is $45,000.
• Current position market price is $43,000.
• Mark-to-market profit and loss is: $2,000 loss.

If prior to the assignment the account was short 1,000 underlying securities, then the account will be left with no stock and short cash of $2,000, or else the account position is long 1,000 underlying securities.

If the contract holder does not wish to be in the long, position or does not have sufficient margin funds, then the contract owner must sell the underlying securities back in the market.

At this point, the contract writer is exposed to market price fluctuations.

Note
Writing (selling short) a put option requires an authorized margin account with the following restrictions: account net worth should be more than $100K, and the proper amount of money to cover probable incurred losses.

A common brokerage firm calculates short-selling risks according to the financial instrument probable volatility called standardized stress of the underlying. For instance, for equity options, narrow based indices, single stock futures, and mutual funds the stress parameter is plus 15%, minus 15% and add the premium received. To illustrate a short put’s required funds, let's take for example writing one put, strike $50.00, stock price at $48.00, 45 days to expiration.

The calculation will be as follows: the risk is on the downside, 52 X 0.85 = 40.8.  Then 50 - 40.8 = 9.2 premium received 3.1, means the account must have funds exceeding 9.2 + 3.1 = 12.3 for every contract (more than three times the premium). The broker monitors margin requirements in real time and will liquidate the account 10 minutes after the margin call, if there is no response fixing the margin requirements.

Examples
In the following examples, we will examine writing put alternatives. You will understand that even if it seems simple to short a put option, you need to explore all alternatives and pick the right contract. Further, you will see which contract better fits your outlook. It all comes to a proper plan of your way to success.

Short ITM, ATM, OTM Put Option Contract
ITM (in the money) put option contracts premium is usually higher. Because of its intrinsic value, it devaluates less from time decay and less sensitive to a change in the implied volatility. On the other hand, the short put option contract will relatively be riskier from a decline in the underlying instrument. If the strategy outlook is very bullish, then you can write this contract.

ATM (at the money) put option contract devaluates more from the time decay and revaluates more from a change in the implied volatility. A put option contract benefits even from a moderate gain in the underlying security value. If the strategy outlook is neutral to bullish, then you can write this contract.

OTM (out of the money) put option contract devaluates the most from time decay and less from a change in the implied volatility. Put option contract benefits the most from a slightly bearish to neutral and of course bullish.