Just like you would do when looking for a bargain, cash secured puts let investors buy stocks at a lower price while earning income. This article will answer the question “what is a cash secured put?”, review the benefits and risks of using this cash secured put strategy, and provide examples to help you understand selling cash secured puts.
Key takeaways
- Cash secured puts are an options trading strategy where investors write an at-the-money or out-of-the-money put option while setting aside the necessary to purchase the stock.
- This strategy is often used by bullish investors who believe in the long-term potential of a stock but seek short-term discounts.
- The difference between cash secured puts and naked put options is a sort of textbook one, and many traders use the terms interchangeably.
What Is a Cash Secured Put?
First things first, let’s clarify what a cash secured put is and its purpose. A cash secured put strategy involves writing an at-the-money or out-of-the-money put option while setting aside enough cash to purchase the stock.
Investors who engage in selling cash secured puts are generally looking to buy the underlying shares of stock, even though they may be happy with the mere premium of their put, which they will earn if the stock price remains above their breakeven level. The general idea is that, instead of purchasing the shares at the current market price, investors aim to have the put assigned so they can buy the shares at a lower price.
What could happen is that the investor may face shares assignment, acquiring the stock at a price below the initial market level. Regardless of whether the put is assigned, all potential outcomes are considered acceptable, as the premium income will contribute positively to the overall results.
An investor who utilizes a cash secured put strategy is typically bullish on the underlying stock and can accept the idea of a temporary price drop. If the stock price falls below the strike price, the put may be assigned, allowing the seller to buy the stock at the strike price. The effective purchase price would be even lower after deducting the premium received.
In the cash secured put example that we will see later using our options screener, the investor opens a trade knowing that there may be a temporary downturn to buy the stock at a favorable price, using the premium income to improve the net outcome. Once again, remember that you don’t necessarily need to aim for assignment, as the simple profit coming from the put’s premium can justify this trade.
How Does Selling Cash Secured Puts Work? Four Simple Steps
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- Set Aside Funds:
Ensure that you have enough cash set aside to purchase the stock if the put is assigned. This is a fundamental part of the cash secured put strategy.
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- Choose the Right Strike Price:
Select a strike price that aligns with your investment strategy. If you anticipate a short-term dip but expect long-term growth, a slightly out-of-the-money put might be appropriate.
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- Monitor Market Conditions:
Stay informed about market trends and the specific stock you are interested in. This helps in making timely decisions.
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- Collect Premiums:
When you sell a put, you receive a premium. This premium acts as a buffer, reducing your effective purchase price if the put is assigned.
The Difference Between Cash Secured Puts and Naked Puts
The difference between cash secured puts and the naked put strategy is a “textbook” one, meaning that they mostly differ for the investor’s purpose, as we explain below.
The key distinction is that the cash-secured put writer allocates funds to buy the stock if it is assigned and sees the assignment as a favorable result.
Conversely, the naked put writer wishes for the put to lose value, avoiding assignment and allowing the position to be closed early for a profit. This type of investor would need to quickly liquidate other assets or borrow cash to meet an assignment notice.
Understanding these differences helps you make more informed choices and select the strategy that best matches your risk tolerance and investment objectives.
Pros and Cons of Cash Secured Puts
There are a few pros and cons that you generally do not want to ignore when considering cash secured puts, and here is a table telling you more about it:
Pros
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- Potential Income Generation:
Selling cash secured puts allows you to collect premium income, enhancing your overall returns.
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- Lower Purchase Price:
If the put is assigned, you can acquire the stock at a price lower than the current market value, thanks to the premium received.
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- Flexibility:
Whether the put is assigned or not, the outcomes are generally acceptable. If not assigned, you keep the premium; if assigned, you get the stock at a lower price.
Cons
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- Substantial Risk:
If the stock plummets, you could be forced to buy it at a much higher strike price, leading to significant losses.
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- Limited Profit Potential:
The maximum gain is limited to the premium received if the put expires worthless.
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- Capital Requiremen:
You need to set aside a substantial amount of cash to cover the potential purchase, which could be used elsewhere.
A Real-Life Cash Secured Put Example
Considering that we told you that, in practical terms, there is no real difference between a cash secured put and a naked put, you could leverage our options screener to find naked put opportunities and turn them into cash secured puts.
Let’s look at a cash secured put example. Take, for instance, our
“High probability Naked puts (85% prob of worthless, good companies, good risk-return profile)” predefined scan. Let us look at Delta Airlines (DAL), currently trading at $49.86.
Suppose you read multiple reports about the company and you believe that its fundamentals are very strong, and you would like to sell an out-of-the-money (OTM) put on DAL. In the worst-case scenario, you would still be happy to hold DAL shares in your portfolio, as you’re sure that, in the long run, this company’s stocks will rise.
So, what could you do? Our options screener may show you the opportunity to sell a $46 put expiring in 2 weeks. You can play with the expiration date, of course. The scan we mentioned above only takes, by default, options expiring before dividend dates or earnings report events. However, if you feel that this is worth the risk, you can edit these parameters and create your own variation of our scan (just duplicate it and save it).
Here’s how the trade would play out:
Trade Details
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- Stock:
Delta Airlines (DAL)
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- Current Price:
$49.86
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- Strike Price of Put:
$46
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- Expiration Date:
2 weeks from today
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- Premium Received:
$0.25 per share ($25 total for 100 shares)
Risk and Reward
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- Breakeven Point:
$45.75 (Strike Price – Premium Received)
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- Maximum Profit:
$25 (Premium Received)
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- Maximum Return (%):
0.54%
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- Maximum Return (Annualized %):
14.3%
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- Potential Loss:
Unlimited if DAL price collapses (mitigated by your fundamental analysis)
You can find the information above in the P&L chart of this strategy:
By selling this $46 put, you collect a premium of $0.25 per share, which comes to $25 since options contracts generally cover 100 shares. If DAL’s stock remains above $46 until expiration, the put expires worthless, and you keep the premium as profit. However, if DAL’s stock drops below $46, you’ll likely be assigned the shares, meaning you’ll buy 100 shares at $46 each. Your breakeven point here is $45.75 (the $46 strike minus the $0.25 premium).
Let’s go a little bit deeper into why you might consider this trade. Based on your research, you believe in DAL’s long-term prospects. The historical price chart shows a support level around $45.75, adding another layer of confidence:
This means if the stock falls to this level, it might stabilize or bounce back, reducing your downside risk.
With this cash secured put, you are setting aside the money to buy 100 DAL shares at $46. This may not seem very convenient if you consider the maximum $25 profit potential of the put you sold. However, it becomes more appealing if you think about the profit you could earn in case of stock assignment. If DAL shares are assigned to you at $46 and then rise, your potential earnings could be significantly higher.
What Could Happen after Assignment? A Positive Scenario
Imagine DAL shares are assigned to you at $46, and then the stock rallies to $55 over the next few months. Your return would then include the increase in stock value plus the premium received:
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- Shares Acquired:
100 DAL shares at $46 ($4,600)
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- Market Value after Rally:
$5,500 ($55 x 100 shares)
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- Market Gain:
$900 ($5,500 – $4,600)
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- Premium:
$25
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- Total:
$925
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- % Return:
20.11%
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- Annualized % Return:
1,869%
This example illustrates how a cash secured put strategy can work in your favor, even if the initial profit from the option seems modest.
In summary, selling cash secured puts on a stock like DAL, backed by solid fundamentals and a strategic use of our options screener, can be a powerful way to generate income and potentially acquire stocks at lower prices. The key is to conduct thorough research, understand the risks, and be prepared for various market outcomes.
Volatility, Time Decay, and Other Factors to Consider with Cash Secured Puts
There are also other factors to consider when dealing with cash secured puts, as we explain below.
Impact of Change in Volatility
Volatility measures how much a stock price fluctuates in percentage terms and significantly affects option prices. As volatility rises, option prices tend to increase if other factors like stock price and time to expiration stay constant. For cash secured puts, higher volatility can mean higher premiums, making it attractive for those selling cash secured puts. However, increased volatility also raises the risk of the stock price dropping below the strike price, potentially leading to assignment.
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- Higher Premiums:
Increased volatility typically results in higher premiums for options, providing more income when selling cash secured puts.
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- Increased Risk:
While higher premiums are beneficial, heightened volatility can increase the likelihood of the stock price falling below the strike price, leading to assignment.
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- Implied Volatility:
An increase in implied volatility makes it more likely for puts to be assigned. This could be advantageous if you’re prepared to buy the stock but requires close monitoring of associated risks.
Impact of Time
Time decay, also known as theta, refers to the reduction in an option’s value as it nears its expiration date. For cash secured puts, time decay works in your favor. As time passes, the premium of the option decreases, benefiting the seller. The closer the option gets to expiration, the faster the time decay, which means the value of the put option will erode more quickly.
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- Benefiting from Time Decay:
As expiration approaches, the value of the cash secured put decreases, assuming the stock price remains above the strike price. This erosion in value allows you to keep more of the premium as profit.
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- Accelerated Decay Near Expiration:
The rate of time decay speeds up as the option gets closer to its expiration date. This accelerated decay can work to your advantage if the stock price stays stable or trends upward.
A Few More Aspects to Consider
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- Good Quality Companies:
When selling cash-secured puts, our scans will show you each company’s “Stock score”. Here, you will be able to check the “Fundamental,” “Growth,” and “Technical” scores for each trade, ranking from 1 (bad) to 10 (good). You should probably favor companies with a higher score to increase your profit chances.
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- Consider your Probability of Profit:
Speaking of which, the price of an option contains, by itself, the implied probability of profit of your strategy. A put may have, for instance, an 82% probability of ending up being worthless by the time it expires. Our scans will show you this approximated percentage value to help you choose the best option to sell.
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- Investor Sentiment:
Market sentiment can influence stock prices and the performance of your cash secured puts. Positive sentiment can lower the risk of assignment, while negative sentiment might increase it. Understanding investor sentiment provides additional insights into potential outcomes.
