What are cash-secured puts?
A cash-secured put is an option selling strategy where the investor's main goal is buying a stock at a price below its current market price by selling put options. In this strategy, the investor will be a seller of put options and will receive an upfront cash payment known as premium for selling the puts. If assigned, the seller will be obligated to buy the security at the predetermined strike price.
This lower price is called a strike price. The put is cash-secured because the person who sells the put option must set aside enough money to cover the purchase value of the stock if it does reach the strike price. A cash-secured put can be like an insurance policy: the buyer of the put pays you a premium and, in exchange, you commit to buying the stock if it reaches the specific lower strike price within the pre-determined time frame. If the stock does not reach the strike price, both parties walk away, and you keep the premium. If the stock hits the strike price, you keep the premium, but you’re also obligated to buy and take possession of the stock.
When an investor sells or writes a cash-secured put, there are only two possible outcomes at the expiration of the option contract:
1. The share price falls below the strike price and the stock is 'assigned'. This means that the seller of the option must buy and take possession of the stock at the strike price, using the secured cash. The seller of the option keeps the premium.
2. The share price stays above the strike price and the seller of the option keeps the premium, and the option expires.
A cash-secured put strategy is considered a short-term bearish strategy because it assumes a stock will experience a short-term dip in price but will then continue to appreciate in value over the longer term.
Investors who want to employ a cash-secured put strategy will need to open a margin account.
How do cash-secured puts work?
Once an investor has selected an option eligible security that they would like to purchase at a lower price or one that they would be willing to purchase if assigned. The next step is making sure there is sufficient cash in the margin account to cover the purchase if needed and then writing (selling) the put option and receiving the premium. If the stock does reach the strike price, the role of the option seller is like an insurance underwriter. As the 'pre-assigned buyer’, they have already put aside the allotted funds in their margin account, and they are obligated to take possession of the stock once assigned.
Unlike a simple buy limit order that may never be filled if the stock does not reach the pre-assigned lower price, a cash-secured put allows the seller of the option to generate income for taking on the risk that the stock will decrease in value and then, potentially, acquire the stock if it descends in value and hits the strike price.
Example of a cash-secured put
Here is an example of how a cash-secured put works:
- Stock ABC is trading at $100 per share.
- Investor A sells one cash-secured put option with a strike price of $90 that expires in 30 days. Remember that one option contract represents 100 shares of stock.
- At the start of the option contract, the buyer of the contract pays a 2$ premium per share to the seller.
$2 premium per share x 100 shares = $200
$90 strike price per share x 100 shares= $9000
- Investor A set aside $9000 in their margin account to cover the value of the stock in the event that it hits the strike price, while the $200 premium is paid out immediately at the start of the contract.
If on day 29, stock ABC hits the $90 strike price, and Investor A is assigned he will pay for the stock from the funds secured in the margin account, which, in our example, is $9000. The $200 premium received at the start of the contract will lower the total cost of the purchase. The $2.00 per share ($200) received in premium has lowered the actual purchase price to $88.00.
Example of a cash-secured put
If the stock doesn't reach the strike price of $90, but stops at $92, assuming that there are no fees and commissions, the investor could still purchase the stock. The premium received at the start of the contract and the cash secured in the margin account would total $9200 – the cost of 100 shares at $92 dollar per share. The investor is still only paying $90 a share because the difference is covered by the premium received at the outset.
On the other hand, if the stock never reaches the strike price in the 30 days, the seller of the option (Investor A) pockets the $200 premium. Both parties walk away, and the option simply expires.
Cash-secured puts vs covered calls
A covered call is different from a cash-secured put because the seller of a covered call owns the underlying stock. While call options are agreements to buy and put options are agreements to sell an underlying stock, a covered call also assumes an increase in the value of the stock as opposed to a cash-secured put which assumes a decrease in value of the underlying security. Although the investor may be holding two separate positions at the same time, a covered call is considered a single position within an investor's portfolio.
Like a cash-secured put, the covered call writer receives a premium from a buyer and sets a particular strike price with a fixed timeframe. If the stock reaches the strike price or goes higher, the covered call writer will be assigned and will have to sell their shares at the strike price. If the stock doesn't reach the strike price the option expires worthless, and the covered call writer keeps their shares and can repeat the strategy if desired.
In either scenario, the seller of the covered call gets to pocket the premium. One of the risks of a covered call is if the stock's price goes much higher than the strike price. In this case, the seller is obliged to sell their stock to the option buyer at the lower strike price – losing any potential gains they may have made by holding onto the stock and selling it at the higher valuation. This strategy can be applied in all types of brokerage accounts.
Why use a cash-secured put?
The main reason to use a cash-secured put strategy is the opportunity it provides to purchase a stock at a lower price. The premium received at the onset of the options contract effectively lowers the purchase price if the stock ends up reaching the strike price and is assigned.
A second reason is that the premium received from writing a cash-secured put generates a cash return. Some investors try to rely on this strategy hoping that the option will not hit the strike price and the contract will simply expire in the hope of repeating the strategy and collecting more premium.
There is always a risk that the stock will reach the strike price and the investor will be assigned the stock. That is why it is key to always use a cash-secured put for a stock that you would like to own.
Factors affecting a cash-secured put
There are a number of variables at play in a cash-secured put. The value of the option and the size of the premium that the investor can receive by writing the put option are based on a combination of factors that include the strike price, the volatility of the option and the underlying security, and the time frame before the expiration of the contract.
- Strike price - As the share price gets closer to the strike price it is also more likely that the premium on the option will be higher. In this scenario, there is also a better chance that the stock will reach the trigger price and the option will be assigned.
- Volatility - An option tied to a more volatile underlying security will pay out a higher premium.
- Time value - If the time frame before the close of the option is long, the option will have a higher premium than an option where the time value is short. Time value is also linked to the concept of time decay, where the value of the option will decrease as the expiration date of the option gets closer.
When to use a cash-secured put?
While they are often considered a bearish strategy because users benefit from a decrease in a stock's value, cash-secured puts can be used in both bear and bull market conditions. The key question that the self-directed investor must ask is how badly do they want the stock?
A cash-secured put in a bullish market
In an upward moving market, or bull market , the most likely scenario is that the value of the underlying stock will continue to rise rather than fall. The seller of the cash-secured put will keep the premium but will not be assigned the stock and could miss out on future capital appreciation. A better strategy would be to simply buy the stock rather than try and acquire it using an option.
A cash-secured put in a bearish market
The risk of selling a cash-secured put in a bearish market is that the value of the stock may continue to go down past the strike price. Once assigned to the seller, the security that they now own continues its descent. The investor is stuck holding a stock or ETF that is worth much less than what they paid.
At least you still bought the shares. In that case you might be better off placing a buy limit order and modifying the price lower if the price seems to be decreasing. This option provides you with more flexibility. The most promising scenario is that you are short term neutral or slightly bearish but bullish over the long-term on the stock’s potential.
Pros and cons of cash-secured puts
Here is an overview of some of the pros and cons of using a cash-secured put option.
- Opportunity to purchase stock at a lower price.
- Keep the premium from writing the cash-secured put if the stock price doesn't move or if it increases in value.
- The cash-secured put strategy can be repeated.
- It can provide additional income on your cash holdings.
- Maximum profit is limited to the size of the premium.
- Maximum loss can be high if the value of the underlying stock falls to $0.
- If the security sees a sudden spike in value, an investor would miss out on the gain compared to if they simply purchased the stock.
- Since cash-secured puts can only be used if investors have margin accounts, some investors might be tempted to borrow money and use leverage instead of having the cash at hand – increasing the investor's overall level of risk.
- Commission and assignment fees can be expensive in some brokerages.
How to choose cash-secured puts?
1. An investor's first step should be deciding on a security that they are interested in holding in their portfolio. There are thousands of option-eligible securities to choose from based on different growth, value, dividend, and other investment criteria.
2. Determine the current trend of the security. Is it bullish or bearish? NBDB clients can use the Technical Insight Tool from Trading Central to analyze the security and determine trend patterns.
Don't forget that if the security is bullish an investor might be better off simply purchasing it.
3. Once you've decided that a cash-secured put is the best option strategy to follow, you will have to determine what strike price and expiration date to select. Some investors can find this step daunting because of all the possible choices. This is where our OptionsPlay tool can help.
The OptionsPlay tool allows investors to customize their preferred timeframe and risk tolerance, or use the default setting. The tool will calculate the Probability of Expiring Worthless (POW) based on the assigned strike price of the put option. A lower POW means that the premium will be higher and there will be a better change that the cash-secure put will be assigned.
4. OptionsPlay will complete the transactional ticket once the investor selects the margin account to draw from and the number of contracts they want to write.
Cash-secured puts are a great way for independent investors to get started and explore the world of options trading. As a conservative and low-risk options strategy, cash-secured puts can mitigate some of the risk and potential losses while helping grow a portfolio. Nevertheless, it is important to remember that markets go up and go down and no investment is risk free. Do your research, invest strategically, and plan for your financial future!