Risk of selling stock cash secured puts and covered calls

Question

I'm trying to determine what the potential downside is for selling call and put options, aside from the obvious loss of money if the stock moves past the strike price of the call or put sold.

Right now, a stock that I follow has about a 7-8% premium of the strike price as the premium for a call or put option with 1 week or less before expiration.

I think that at 7-8% per week, it would make a ton of sense to sell cash secured puts to collect that premium. If they expire, I'll continue selling puts. If assigned, I'll sell weekly covered calls for another 7-8% of premium.

So far, I'm missing the downside. I see a potential that the stock price could drop X amount below my break even (strike price less premium received) but I feel that the risk of this is low as the drop isn't likely to surpass the 7-8% premium I'm getting for the short put.

To the up side, I understand that selling a covered call limits your profit potential once the strike price is reached. So unless the stock I'm looking at consistently fluctuates by more than say +/- 10%, I am having trouble understanding why this isn't 'easy money'.

Is there something I'm missing here?

Answer 1

Your analysis is correct other than a conclusion of it being easy money.

The first problem I see is the 7-8% premium per week. If you're evaluating an ITM option then you have to calculate return if unchanged and return if the option expires. If ITM, the intrinsic value is premium but it is not profit unless the stock rises and the option expires.

If this is an ATM or OTM put, then the implied volatility is huge and there's something lurking (a pending earnings announcement or clinical trials results, etc.) and that's a one off deal, not an every week event. With such a high IV, there's an expectation of a large price move in the underlying. If there's no event pending then there's some other problem that has to be ferreted out.

Selling naked or cash secured short puts should only be done if it's a stock that you are willing to own at the net cost. Do not chase fat premium.

A short put is synthetically equal to a covered call. Both have an asymmetric risk graph with limited profit potential and all of the downside risk (less the premium received).

IMO, a vertical spread is a better approach since it is risk defined. It shifts the R/R closer to even and has a much lower margin requirement than a short put.

Prior to expiration, the vertical will lose less than the short put because the long put of the vertical gains in value during a drop.

Comparing the strategies, at expiration, the break for the vertical versus the short put is the long strike less the premium paid for it. Above that BE point, the short put outperforms. Below it, the vertical loses nothing more while the short put continues to lose.

With the spread you get a much higher ROI and no chance of getting whacked if the stock collapses. Is giving up a piece of the short premium worth a higher ROI and disaster protection? That's a personal choice - I say yes. Higher vols provide a larger spread credit. Lower vols presents a more challenging choice as do wide B/A spreads.