Make money while you wait and do nothing.
That’s the good life.
A cash-secured put is a conservative technique that is best utilized to get paid to pick up stock at a lower price.
Have you ever wanted to purchase a stock at a lower price? Instead of just waiting for the stock to move lower you can sell a cash-secured put to make that happen.
Cash-secured puts are simply, short puts with the intent of purchasing the stock at the strike price.
We need an example to help explain.
The Option Prophet is currently trading at $50. You think it is a bit overpriced and would like to own it if it drops down to $45. Your first choice could be to sit and wait for it to move lower. Or, you could sell a put at the 45-strike for $3.00 and wait for TOP to move lower. If TOP moves below $45 you will be assigned the shares.
Cash-secured puts are an underutilized strategy. Before you start selling puts on every stock you want to own we need to discuss the specifics of the puts, what happens if you are assigned, not assigned, and the downfalls of the strategy.
Which Options Should You Use
When hunting for the perfect put to sell we need to take a couple of factors into account.
The first thing we need is the strike price. The strike price should be the price you are willing to pay to purchase the stock.
Using our example from above. If TOP falls below $45 by expiration, you will be assigned. If you sold one contract your total cost would be $4,200.
# of Contracts x Strike Price – Premium = Total Cost
1 x 45 – 300 = $4,200
Not only do you need to be okay with purchasing the stock at this price, you need to have the money reserved to make the purchase.
Strike price is the easy metric to figure out because you set the number. If you think the stock is currently overvalued, you can sell the put at the price you think the stock should be to be fair.
Maybe fundamental analysis is not your cup of tea.
If you are studying a stock chart and see a strong support level you want the stock to pullback to, sell your put at that price level.
We know you’re going to sell a put and you know at what strike price, but what expiration month should you pick?
The whole idea of a cash-secured put is that you have the cash waiting to buy the stock. If you want to sell a put that has six months to expiration, you are going to have to keep your cash on hold for six months.
You must figure, no matter how far the stock drops below your strike price, you will not be assigned until expiration.
Ideally, you want to sell options one to three months out. This will, typically, give you a good return on your premium without tying up your money for months on end.
Since option premium will be more expensive the further you go out in time you cannot just compare premium from one month to the next.
You need a way to level the field when comparing option premiums. The best way to compare premiums over multiple periods is to annualize the returns.
The formula to annualize your returns is:
((1 + (Premium) / (Cost of Shares) / (Days to Hold)) ^ 365) – 1
If we continue to use the example from above, assuming the holding period is 60 days out, our annualized return would be:
((1 + (300) / (4500) / (60)) ^ 365) – 1
((1 + 0.066 / 60)) ^ 365) – 1
(1 + 0.0011) ^ 365 – 1
1.0011 ^ 365 – 1
1.4937 - 1
49.97% Annualized Return
This is the mass appeal to cash-secured puts. You can sit and wait for your stock to come back to you and not sell puts. Or, you can sell a cash-secured put, make a 49.97% annualized return on your option, and still pick up the stock.
Setting up a spreadsheet to figure out the annualized return is an easy task and it will make comparing multiple options over multiple time periods very quick.
What Happens If You Are Assigned
If the stock falls below your strike price by expiration, your put will be in-the-money. If it remains in-the-money at expiration, even by one-penny, you will be automatically assigned. When you are assigned, every contract you have will purchase 100 shares of stock.
For example, if you sold 5 contracts of TOP and you are assigned, you will purchase 500 shares.
Because you sold a put and collected a credit, the option premium, this will go towards your overall cost basis.
Still using our example from above. You sold one put contract on TOP at the 45-strike for $3.00. If you are assigned your breakeven on the stock is now set at $42.
Strike Price – Premium = Breakeven
45 – 3.00 = 42
Once you are assigned you will own the shares and now you can hold them, collect dividends, or begin to sell calls on them and generate more income using the Wheel Trade.
What Happens If You Are Not Assigned
If you are not assigned on expiration your puts will expire worthless. A put that expires worthless will disappear from your account by the next day and you will keep the full premium. This will now free you up to either, sell another put at the same or different strike or move on to a different stock.
If you are not assigned, you can figure out your return on the premium to be 6.67%.
Our return formula is: Premium / Cost of Shares
In this case: 300 / 4500 = 6.67%
The Pitfalls Of Cash-Secured Puts
Every strategy has its pitfalls and this one is no different. There are two scenarios that create a downside in this strategy.
First, if the stock does not move lower but instead moves higher. If this happens you will not be assigned on the stock, which means you will not receive the shares that you wanted. As the stock moves higher, you will be left watching and missing out on the gains it could have provided.
If this were to happen, the put you sold would begin to lose value, short puts are a bullish strategy so you would make money. As the puts lost value, you could buy them to close, make a smaller profit, and then either buy the shares at their current price or sell another put at a higher strike.
The second scenario is having the stock move lower and then continue to move lower. In an ideal world, you would want to the stock to move to your strike price, get assigned the shares, and then have the stock take off higher.
Unfortunately, the stock market rarely operates in an ideal world. If the stock moves to your strike price by expiration, you will be assigned the shares. If the stock continues to move lower, you will have a loss on your hands.
No one likes a loss in their positions, but think about it this way. This is a stock you already wanted to own and could acquire at a lower price compared to where it was trading previously. Because you took in a premium from the option sale, you have lowered your breakeven price.
If you decided you didn’t want the shares anymore, you could buy to close the puts and close them out. This would result in a loss since the puts would have gained value as the stock decreased. Therefore, it is a good idea to make sure this is a stock you want to own at the strike price.
While neither scenario is ideal, the overall outcome is not horrible.
If you are a buy and hold investor or just want to acquire stock it is a good idea to use cash-secured puts. Cash-secured puts have several advantages if you can afford the time to wait (keeping note, you will make money while you wait).
Cash-secured puts are a beginner option strategy due to the lack of overall risk so brokerages typically have them as an option level 1. You must have enough cash to buy the stock if you are assigned, so keep that in mind when you decide the number of contracts to sell. As Harry Sit from the Finance Buff noted, “Use this strategy only when you are truly committed to buy at the set price. Don’t speculate.”
The benefits of using short puts to pick up stock will be to receive a premium while you wait for the stock to move lower. Plus, when you receive a premium you will lower your breakeven cost on the overall position.
The downside is that the stock could run away without you in it. It could also tank after you picked up the shares, giving you an immediate loss.
Pairing cash-secured puts with covered calls create an income strategy known as the Wheel Trade. The Wheel Trade is an excellent way to increase your income by rotating stocks in and out of your portfolio.
What stocks do you pick up using cash-secured puts? Tell us in the comments...