to be more risk than usual of future volatility. The question remains: Is the
higher premium worth the risk?
The answer to this question is subjective. Part of the answer is based on
Stacie’s assessment of future volatility. Is the market right? The other part is
based on Stacie’s risk tolerance. Is she willing to endure the greater price
swings associated with the potentially higher volatility? This can mean
getting whipsawed, which is exiting a position after reaching a stop-loss
point only to see the market reverse itself. The would-be profitable trade is
closed for a loss. Higher volatility can also mean a higher likelihood of
getting assigned and acquiring an unwanted long stock position.
Cash-Secured Puts
There are some situations where higher implied volatility may be a
beneficial trade-off. What if Stacie’s motivation for shorting puts was
different? What if she would like to own the stock, just not at the current
market price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her
trading account to secure the purchase of 1,000 shares of Johnson &
Johnson if she gets assigned. The $63,250 is the $65 per share she will pay
for the stock if she gets assigned, minus the 1.75 premium she received for
the put × $100 × 10 contracts. Because the cash required to potentially
purchase the stock is secured by cash sitting ready in the account, this is
called a cash-secured put.
Her effective purchase price if assigned is $63.25—the same as her
breakeven at expiration. The idea with this trade is that if Johnson &
Johnson is anywhere under $65 per share at expiration, she will buy the
stock effectively at $63.25. If assigned, the time premium of the put allows
her to buy the stock at a discount compared with where it is priced when the
trade is established, $64. The higher the time premium—or the higher the
implied volatility—the bigger the discount.
This discount, however, is contingent on the stock not moving too much.
If it is above $65 at expiration she won’t get assigned and therefore can
only profit a maximum of 1.75 per contract. If the stock is below $63.25 at
expiration, the time premium no longer represents a discount, in fact, the
trade becomes a loser. In a way, Stacie is still selling volatility.