In the world of options trading, cash secured puts have emerged as a popular strategy for investors seeking to generate income while potentially acquiring stocks at a discounted price. This article delves into the intricacies of cash secured puts, explaining how they work, their associated risks and benefits, and practical examples to illustrate their application.
Whether you’re a seasoned options trader or a curious investor looking to expand your repertoire, understanding cash secured puts can open up new avenues for income generation and strategic stock acquisition.
What Is A Cash Secured Put?
Cash Secured Put Example
A cash-secured put (covered put) is an options strategy that involves selling a put option on a stock you’re interested in owning and simultaneously setting aside enough cash to buy the underlying shares at the strike price of the option if it gets assigned.
How it works: Cash Secured Put
A cash secured put works by selling a put option on a stock you’re willing to own, while setting aside enough cash to buy the stock at the option’s strike price.
If the stock’s price stays above the strike price, you keep the premium as profit; if it falls below, you buy the stock at that lower price.
Step-by-step analysis
- Choose a Stock and Strike Price: First, you pick a stock that you’d like to potentially own and a strike price at which you’d be comfortable buying it. The strike price is the price at which you agree to buy the stock if the option is exercised.
- Sell a Put Option: You sell a put option for that stock at your chosen strike price. By selling the put, you receive a premium (the price of the put option) from the buyer right away.
- Cash Secured Part: The “cash secured” part means that you set aside enough cash to buy the stock at the strike price if the option is exercised. This cash must be available in your account until the option expires or is closed.
- Possible Outcomes:
- If the stock price stays above the strike price at expiration, the put option will expire worthless, and you keep the premium as profit. You don’t buy the stock.
- If the stock price falls below the strike price at expiration, you will likely be assigned to buy the stock at the strike price, using the cash you’ve set aside. You still keep the premium.
Risks & Benefits of Cash Secured Puts
“How risky is selling cash secured puts?”
Selling cash secured puts carries moderate risk. The main risk is potential stock ownership at a price higher than the market value if the stock’s price drops significantly.
Pros and Cons
| Benefits | Risks |
|---|---|
| Income Generation: Earns premium income. | Stock Ownership Below Market Price: Might have to buy the stock at a higher price than the current market value. |
| Purchase at a Discount: Potential to buy the stock at a lower price than when the put was sold. | Opportunity Cost: Funds used to secure the put could be invested elsewhere. |
| Defined Risk: Loss is limited to the difference between the strike price and the stock price, minus the premium received. | Limited Profit Potential: Profit is capped at the premium, regardless of stock price increase. |
| Flexibility: Choice of strike price and expiration to suit investment strategy. | Market Risk: Exposure to overall market downturns, affecting stock prices negatively. |
Since you’re prepared with reserved cash, the financial impact is somewhat controlled, compared to other trading strategies that might involve leverage or margin calls.
A Realistic Example
1. Stock & Stock Price
Suppose you’re interested in buying shares of XYZ Company, which is currently trading at $50 per share. You’d like to purchase it at a lower price, so you decide on a $45 strike price.
2. Sell a Put Option
You sell one put option contract (equivalent to 100 shares) on XYZ with a strike price of $45 and an expiration date one month away. The premium received for selling this put option is $2 per share, totaling $200 for the contract.
3. Cash Secured
You must ensure that you have $4,500 in your trading account to cover the potential obligation of buying 100 shares at $45 each if the put option is assigned.
4. Possible Outcomes at Expiration
- If XYZ stays above $45: The put option expires worthless. You keep the $200 premium as profit, which is a nice return without even purchasing the stock.
- If XYZ falls below $45: You are assigned to buy 100 shares of XYZ at $45 per share, despite the current market price. You effectively pay $4,300 ($4,500 minus the $200 premium) for shares that may be worth less in the market at that time.
Trading Tips for Cash-Secured Puts
This may all seem a little bit confusing… Or, it’s maybe too much info coming towards you at once.
Let us help you with a few tips:
- Choose Familiar Stocks: Only sell puts on stocks you understand and are willing to own. This reduces the risk as you’re more likely to know when the company is undervalued or overvalued.
- Pick a Comfortable Strike Price: Set the strike price at a level where you’d be happy to buy the stock. This price should represent a good value for the underlying asset.
- Monitor Expiration Dates: Opt for expiration dates that align with your investment strategy. Shorter durations can mean less risk of significant price changes, while longer terms might offer higher premiums.
- Manage Your Cash Reserves: Since this strategy requires you to potentially buy the stock, ensure you always have sufficient cash to cover the purchase. Avoid using these funds for other investments.
- Consider Volatility: Higher volatility often means higher premiums, which is beneficial when selling puts. However, be mindful that it also increases the likelihood of price swings that could force you to buy the stock at an unfavorable price.
Conclusion
The bottom line is: selling puts can be a strategic and profitable approach if you are knowledgeable about the stocks and market conditions, and are financially prepared to handle the obligation to buy the stock if the market moves against you.
Frequently Asked Questions
Do you earn interest on cash secured puts?
No, you do not earn interest on the cash set aside for cash secured puts. This cash must be available to potentially purchase the stock, so it cannot be used for other investments that might earn interest.
Is a cash-secured put bullish?
Yes, a cash-secured put strategy is generally considered bullish to neutral. It reflects a trader’s expectation that the stock will either remain flat or rise over time, which allows them to keep the premium without buying the stock. However, the trader must also be willing to purchase the stock at the strike price if it declines, indicating some level of confidence in its value or potential recovery.
Is selling puts a good idea (or safe)?
Selling puts, particularly cash-secured puts, can be a good strategy under certain conditions, but it comes with its risks and is not necessarily “safe” for every investor.
Good Idea When:
- You Want to Own the Stock: It’s beneficial if you’re looking to buy the stock at a lower price than the current market value.
- Seeking Additional Income: The premiums received from selling puts can be an attractive source of income.
- Market Conditions Favor It: In a stable or rising market, the risks of the stock falling significantly below the strike price are reduced.
