Here’s a rough flowchart of my current CSP strategy.
I am still actively tweaking my process; so the following only represents a snapshot of my current thinking.
The first step is to search a good candidate. Usually, I have about 20-30 stocks on my radar. These are stocks I am interested in owning. Some of these are companies I already own, but want to own more of.
In any case, I have a reasonable guess of the intrinsic value, IV, for this set of companies. Some of them may be trading below IV (price p < IV). If they trade at a sufficient discount, I will consider buying them outright. Usually, I like to buy stocks for at least a 20-25% discount to IV. This represents my margin of safety (MOS).
But what do I do, if the discount is not large enough? Say,
IV - MOS < p < IV.
I use this condition as an initial filter.
At any given time, depending on the overall market, 3-5 stocks may pass this filter. Two stocks, I am looking at, that pass this filter currently are MSM (IV ~ $85-90), and WFC (IV ~ $55-60). If MSM or WFC traded around $60-65 or $40-$45, respectively, I’d buy the stocks outright.
The second important filter is liquidity. When I am buying stocks, I usually don’t care about liquidity, because my holding periods are usually long. I don’t trade positions frequently. This freedom allows me to buy small-cap and foreign stocks.
With the CSP strategy, however, I need a fair bit of liquidity, since (option) holding periods (more on this later) are usually of the order of one month, and bid-ask spreads on illiquid names can be brutal.
This restricts the universe to somewhat large cap names, say market cap greater than $5B. This number is a guide, not a strict threshold. I like to see open interest for upcoming ATM options to be greater than a few hundred. Usually, both these facts are correlated.
WFC has a market cap over $250B. MSM is much smaller, ~$4B. The open interest for the $50 WFC put expiring on Oct 20 is about 5000. The comparable number for MSM is about 10. So WFC passes the second filter; MSM doesn’t.
The third filter is stock price. I like the stock price to be around $50 or below. This seems quite arbitrary, but is a self-imposed constraint because of position sizing and tactical considerations.
Right now, I like to restrict new positions that I ease into using CSPs to a maximum of 5% of my portfolio. At my current portfolio size, this means a total outlay of between $20-25K. Unlike many options traders, my goal – my ideal outcome – is to buy with a sufficient margin of safety. CSPs are a way to reduce the effective buy price below that level.
The main reason for the $50 stock price filter is that I might embark on long CSP campaigns. Sometimes, this means committing additional capital to the position if it moves deeper in the money.
I like to have 4 slugs in my revolver ($20K outlay/4 options ~ $5K/100 shares ~ $50 price threshold). This gives me added flexibility to adapt, adjust, and exploit volatility.
The final filter is price of the option. I target a minimum return of 20% IRR. If I commit a certain amount of cash to a new CSP, I seek annualized returns on that capital of 20% or more. I will discuss this filter in more detail in a separate post, because there is a fair amount of nuance.
If a stock has fallen in the recent past, its implied volatility is often high (say >30%). These are ideal candidates to chase, since the fall in stock price may have brought them close to value territory, making the pursuit all the more fruitful.
To recap, I search for the following characteristics:
- attractive stock, but not cheap enough, 0.75 * IV < p < IV
- liquid options market (generally large cap >$5B)
- p <= $50, approximately
- initial hurdle IRR > 20% (high implied volatility helpful – but check upcoming events)
Okay, once we’ve figured out we want to pursue this strategy on an attractive candidate, we write or sell ATM puts on 1/4 or 1/2 of the intended position, with a duration of about a month. Why?
We sell at ATM options, because they have the thickest time value premiums. Ideally, we want to maximize these as we are going in. Later, we may be have to be content with ITM puts, which are less juicy, but we aim high to begin with!
How to size the initial position? This depends on how large the margin of safety is at the current price. If it is reasonably large, then I’d go with half. If it is not large enough, then I go with a quarter. This usually ties up $5-10K in the first round.
Finally, I usually try to sell options about one month out. You can get higher IRRs by using weekly options if they are available. This involves more frequent trading (potentially higher commissions), and careful upkeep. A frequency of one month is short enough to capture a fair chunk of the fastest decay in time value, and long enough to suit my temperament and schedule.
To summarize, we start a CSP campaign by,
- writing ATM or slightly OTM puts,
- on 1/4 – 1/2 the intended final position (depending on MOS),
- with a duration of about a month.
Then we collect the premium and wait.
Several things can happen. One outcome is that the underlying stock shoots up, and moves far away from the strike price of the puts we wrote. If that happens, it may be worthwhile to close the position prematurely. Suppose,
G = initial premium collected = maximum gain
T = initial duration of the put (in days)
t = current time to expiry
g = gain on the position at current time (g < G)
Currently, I use a rough rule of thumb.
If the gain on the position exceeds 75% of the maximum possible gain, within the first half of the intended holding period, then I close position. Mathematically, this condition can be expressed as.
t < T/2 and g >= 0.75 G
The reason for not continuing to hold on to the position is that it frees up capital.
Thus, if the stock spikes, and then falls down again, you may be able to exploit the volatility by collecting twice on the same stock. In reality, things can work out even better. When the price of the security rises, its implied volatility falls. That, and the moneyness of the position make it cheap to buy it back. If the stock falls back, generally implied volatility increases, and you can juice out more time value from an ATM option.
At expiry, you encounter one of three possibilities. Let’s dispose of the easy ones first.
If the stock prices exceeds the strike (p > S), you let the position expire. Depending on the price, you may consider reestablishing a new position at a later time.
If the stock prices hovers around the strike (p ~ S), or slightly below, you can roll out the position. This means you close the current put, and write a new put one month out. This lets you collect additional premium, or lower the effective buy price.
If the stock price has gone substantially below the original strike, things get interesting. This is where experience may be invaluable. I haven’t been doing CSPs systematically for long, but think that I have already gotten better at a few things.
In any case, you have several options; you could,
- take delivery – if you have reduced your effective buy price to a point where it is sufficiently below the intrinsic value, then it might be a good idea to take possession. Remember the overarching goal of the strategy is to buy good companies at a cheap price.
- roll out – If you aren’t still happy with the effective buy price and have no new capital to commit, you can roll out the position. Note that the premium for ITM or deep ITM options may not be terribly attractive. Increasing the duration beyond one month might help add a little meat on the bone, but it will hurt your overall IRR. That said, it is a fine default strategy.
- add position: if you have dry powder left (this is why I like four slugs in my revolver), you have more flexibility. There are multiple flavors, you could (i) keep the strike the same, (ii) lower it, or (iii) lower it and add extra duration. The first option (keep strike same) usually gives you the fattest premiums – it works best, when you think the stock has gotten really cheap and you want to lock in this cheapness. You fully expect the stock to rebound before the next expiry. The second or third options (lower strike/add duration) are worth considering, when you think the stock is headed even lower. You may take an IRR hit extending your position this way, but you are playing the long game. This way you reduce your effective buy price, and set yourself up to write future options that are less ITM (and collect fatter time premiums).
- use a wheel strategy: this involves some combination of the alternatives laid out above, and requires additional dry powder. You take delivery of the ITM options, write slightly OTM covered calls on these options, and use your dry powder to simultaneously write ATM or slighly OTM puts.
In future posts, I will highlight specific examples using this template.