Can someone help me understand downside on a CSP?
Here are details on a CSP I am considering but would love to understand insight outside this example as well.
Stock price is $4.50 now. I'm bullish on the stock. Considering a CSP with strike at $4, 212 DTE, premium is $1.87. As I understand it, if I sell one contract I'll collect $187 premium today and my broker will hold $400 for 212 days. If the stock tanks, I'll lose the $400 but get 100 shares; otherwise the option expires and my $400 deposit is returned.
I'm looking at this as $187 / $400 = 46.75% return over 212 days, or ~80% annualized return. I'm bullish on the stock and wouldn't mind owning it long for $4/share. I'll break even at $2.13, and if I buy at $4.50 it will need to get to $6.60 to match the return of the CSP.
Is this the right way to look at it? Sounds too good to be true so would like to know what I'm missing? Is the only real risk that the stock goes below break-even?
Posted by rockstarrichg
11 Comments
Your assessment is good. The only real downside to a CSP is if it drops below your strike. For example in your case, if you get the strike at $4 and the stock drops to $3.50, you will pay $4 for a stock that is worth $3.50. If you believe in the stock that probably won’t bother you.
The general downsides of CSPs are that they have limited upside potential and a lot of downside risk. But with a $4 stock, there’s not that much downside risk. If premiums are that high on a $4 stock, though, you are more bullish than the average investor in that stock. But that’s what makes a market.
Liquidity can be an issue. The bid-ask spread can be wide with cheap stocks and long-dated options. Be careful getting filled when entering and exiting the trade.
You wouldn’t even have to have $400. Max loss on this is $213 so that’s how much you’d have to keep with the broker. The return then becomes $187 on $213 so even better. The question is, what are the risks? If the option is priced this highly, it means the market thinks there’s a good chance that this stock tanks in the next 212 days. What could cause that is hard to say without knowing what the ticker is, but be weary. You only get that return if the stock isn’t below $4, and you are down money if it’s below $2.13. That’s the downside. How likely it is, is up to your due diligence.
The downside is you didn’t protect yourself by buying a lower strike put in case some disaster happens. I learned the hard way. Stocks CAN drop 30-40% overnight and you can’t get out because the market is closed.
If it drops below the strike you lose money because you have to buy the stock at a more expensive price.
If it moves up you lose money because you missed the opportunity to buy the stock when it was cheaper.
In general, if you wanna buy a stock you’re better just buying it. A cash secured put can be a good play if you think the option market is mispriced. Considering the complexities of option pricing, properly detecting if an option is mispriced is pretty much impossible for a retail.
That’s an implied vol over 180% for 2/3rds of a year. The market is telling you there’s 2 outcomes for this thing, 0 or way higher.
Biotech?
Lower priced stocks tend to have more risk, so be sure to factor that in.
CSPs profit from theta decay which ramps up in the last 60ish days, so you may find you would make more money faster by opening a 60 dte put and then close or roll to another instead of 212 dte. You will also be locked into the trade for a long time even if the stock moves up or down but 30-60 dte will allow time to adjust if needed.
You are absolutely correct. Cost basis would be price paid minus premium received
Not too good to be true – its just the math! It really does depend on what your goal is. If your goal is to just reduce your cost basis on a stock you would like to own then that’s totally fine! On the other hand if your goal is to “make money” on a stock that you think will go up then the downside is if the stock falls below your strike price you’ll be paying a little bit more for the stock (less the credit received).
Only sell them if you want to buy that stock at a lower price or only use them if you want to average down and only use them if you are long on that stock.
Well, its also limited bullish. If the stock goes to $50, youll wish you just bought shares or calls. Youll make pennies while bulls made dollars.
But your math is right, yes.