What Are Cash-Secured Puts?
P ut options give you the right, but not the obligation, to sell an underlying asset at a set price by a predetermined expiration date. Investors often purchase put options when they anticipate that the stock market will fall. There are many different strategies you can use to make a decent profit from put options. Let’s explore cash-secured puts in particular.
- Put options are a contract that gives you the right, but not the obligation, to sell 100 shares of an underlying asset at a set price within a set period of time.
- Cash-secured puts are when you write a put option while at the same time setting aside money to purchase the stock if assigned.
- The main advantages of sell cash-secured puts are that they offer price flexibility, upfront cash flow, funds for reinvestment, and the chance to own lower-yielding securities.
- Some investors stay away from cash-secured puts because they require active trading, create tax implications, don’t offer the same ownership as stocks, and come with a risk.
What Are Cash-Secured Puts?
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A cash-secured put, also called a cash-covered put, is an investment strategy where you write a put option while at the same time setting aside money to purchase the stock if assigned. The purpose of this strategy is to be assigned and get a stock below its current market price. Even if the put isn’t assigned, any of the outcomes are desirable. Your income from the premium can help with the overall results.
The idea is that the investor is bullish on the underlying stock — they hope for its price to fall temporarily. If the stock falls below the strike price, a put writer has the chance to be assigned the stock and purchase it at the strike price.
In order to fully grasp what this strategy entails, you need to understand what stock options are.
An option is a contract between two parties where the buyer of the option has the right, but not the obligation, to buy (call option) or sell (put option) 100 shares of an underlying asset at a set price within a set period of time. The idea is that you buy or sell based on the direction of the stock. If you think the stock will fall, you can purchase a put option and exercise your right to sell. If you believe a stock’s price will rise, you can purchase a call option and exercise your right to buy.
Key Characteristics of Cash-Secured Puts
Cash-secured puts usually involve selling at-the-money or out-of-the-money put options. At the money means that an option’s strike price is identical to the cost of the underlying security, while out of the money means that the options contract only holds extrinsic value and no intrinsic value.
When selling cash-secured puts, you have the possibility of buying shares below the current market price with funds you have set aside. Keep in mind, if the shares are assigned, you have the risk of owning the stock or exchange-traded fund (ETF). When taking such a risk, you can reap the benefits by earning money on put option premiums or earning additional interest on the funds you have set aside.
With a cash-secured put, the assignment isn’t guaranteed. This means that you could miss out on a buying opportunity it the shares never fall in price. You might have to pay more than the current market price if you buy shares after a rally. If they are assigned, the shares may not only dip — they may drastically fall. You could experience significant losses if the stock falls to zero.
Advantages of Selling Cash-Secured Puts
Cash-covered put selling can be a lucrative way to generate a steady income. Learn the main benefits of this investment strategy:
- Upfront payment: When you sell cash-secured puts, rather than waiting to see how a stock will do, you receive the option premium right away. If you choose the right security at the right price, you can make a serious chunk of change.
- Immediate reinvestment: By getting paid upfront, you can take this money and use it for other investments. As soon as you make your sale, you have capital in your pocket. Since time is money, getting that money reinvested quickly can be quite beneficial.
- Choose lower prices: Implementing a cash-secured put strategy gives you more price flexibility since there are many available strike prices and expiration dates, so you aren’t limited to open market prices. If you want to own a stock for a specific price, you can create that agreement while getting paid to do it. Later on, if you decide that you want to own the stock at a lower price, you can change your agreement, and then you’ll get a lower premium for this lower purchase price.
- Own lower-yielding securities: Selling a cash-secured put gives you the opportunity to get paid for compromising on a lower price. This additional cash flow gives you more opportunities.
Disadvantages of Selling Cash-Secured Puts
Of course, with every type of investment comes a level of risk. Let’s go over some potential drawbacks of selling cash-covered puts:
- Stuck with 100 shares: Every put option consists of 100 shares of an underlying asset. Depending on how much a stock is worth, you may have a hard time finding an investor who wants to buy that many shares. For example, if a stock is going for $5 a share, $500 isn’t much to many investors. However, the same can’t be said for stocks listed at $2,000 a share.
- Don’t have the same ownership: Options don’t give you the same ownership as you get when you buy stocks outright. If you want to receive dividends and voting rights, then this may not be the best strategy for you. The only cash flow you have in this scenario is your premium until you exercise the option or let it expire.
- Need to pay more attention: Since options have expiration dates, you need to be mindful of when you need to exercise your rights. Each time your options expire, you need to restart the strategy by selling additional cash-secured puts. This all requires a lot of time and isn’t ideal for passive investors.
- Additional tax implications: Every investor knows that the more investments they have, the more complicated their taxes become. In the case that you don’t exercise a put option, the premium of the option could be taxed as short-term income. If you do exercise it, the option premium is a part of your future tax consideration and cost basis. Of course, this all depends on how long you held on to the underlying security. These tax implications are much more complicated than those of qualified dividend payments.
Rules to Follow When Using Cash-Secured Puts to Generate Income
Follow these rules when selling cash-secured puts for income:
- Determine if you want to own the stock at the set strike price. If your option ends up below your strike price by the expiration date, you could buy a discounted stock and get paid to do so. If the stock happens to go below your strike price, you need to decide if you’re still willing to own it. Reflecting on this scenario can help you determine whether this strategy still makes sense for you.
- Do your research. Consider factors like earnings growth, price-to-earnings ratio, price-to-cash flow ratio, price-to-sales ratio, PEG ratio, and return on equity before doing anything. These measurements can help you find out if a stock is undervalued and could be set up for outperformance. You need to know if you’re willing to own these shares.
- Chose your expiration month and strike price wisely. All put options go through time decay, meaning that the closer they get to their expiration date, the faster they lose value. Keep an eye on the Greeks to assess the risk of your put options. Theta can tell you a lot about their time decay.
Other Important Options Terms
When starting to trade options, you need to understand these terms:
- Long put: A long put is when you buy a put option to open a new position. The put gives the owner the right, but not the obligation, to sell 100 shares of an underlying stock at a set prince within a fixed timeframe.
- Short put: A short put is when you sell a put to open a new position. By writing — or selling — the put option, you are showing your openness to purchase the shares at the strike price within the set timeframe.
- Protective put: This is a long put that is intended to protect the underlying stock’s position.
- Covered call: This refers to when an investor writes one or more equity call contracts while buying an equivalent amount of underlying shares.
- American options: In America, you can exercise your rights any time before or on the expiration date.
- European options: In Europe, you can only exercise your rights on the expiration date, not before it.
Selling cash-secured put options is ideal for more seasoned options traders. It’s essential to have a good grasp of what you are doing so that you can make smarter decisions. If cash-secured puts aren’t for you, consider learning about other options trading strategies instead.