When it comes to investing, there are numerous strategies that traders can utilize to generate income or potentially acquire stocks at a lower cost. One such strategy that deserves attention is cash-secured puts. In this blog post, “Cash-Secured Puts explained” we will provide a comprehensive breakdown of how they work, and the potential benefits and risks associated with this options trading strategy.
Understanding Cash-Secured Puts
A cash-secured put is an options trading strategy that involves selling a put option, this means you have the obligation to purchase 100 shares of the stock the put was sold on, you receive a premium for taking on that risk, while simultaneously setting aside enough cash to cover the potential purchase of the underlying asset if the option reaches the strike price and is exercised.
Let’s break down the key components:
Identifying a stock
Stock selection is one of the most important parts of this strategy, you might decide that you want to own shares of a specific company for a multitude of reasons centered around the future value of the company. As part of your trading plan, form a strategy around how long you’d like to hold the stock for if you get assigned those shares. The less capital you have the riskier the stocks you initially pick will be. For example, if you only have $500 you will be limited to stocks that are under $5 a share since selling a put option consists of buying 100 shares of a given stock upon assignment.
Securing cash
Set aside enough cash in your account to cover the potential purchase of stock.
The reason cash secured puts are an ideal strategy to undertake is because anyone can get started with this strategy whether they have $500 or $5000. For every successful trade made you get to keep the premium you received, typically around 2%-4% per month. With time and the right approach your returns will slowly compound, and you will see your account size grow. Adding a little fuel to the fire with a consistent injection of cash into your account will only increase your returns over time.
Selling a put option: Selecting a strike price
When you are in the process of deciding which stock to open a position on, one of the things that will determine how successful you are as an option seller is how you select your strike price on trades, this means the cost per share at which you are willing to own the shares.
Typically, when you select a strike price, you’ll want your entry point to be below the current share price of the stock to give you a margin of safety, but sometimes there will be some exceptions to that rule depending on how aggressive you’d like to be. For example, a stock like PayPal which as of July 2023, is down 80% from its highs might warrant a more aggressive approach than a stock like Tesla that is up almost 50% in a few weeks as of the writing of this article.
When you see opportunities in the market, your strategy should be flexible enough to take advantage of them. When you are selling puts you must assume you will eventually get assigned, so it makes more sense to get assigned shares of the stock that is down 80%. One of the main goals of using this strategy is to gain a better entry price and purchase undervalued stocks.
The two best put selling strategies
The biggest determining factor of your success as a put seller is understanding what your approach is to any given trade. Your approach to one trade might be to gain a better entry on the stock you are trading, or your approach could be to simply generate income with no intention of getting assigned.
Let’s look at these two approaches.
Put selling to gain a better entry price
With this put selling approach your goal as an option seller is to gain a better stock entry with the added benefit of collecting a premium which again is usually between 2%-4%. This premium also lowers your cost basis on the stock position you are expecting to get assigned.
As long as you’ve done some solid analysis on the stock, getting assigned the shares you should be something you look forward to.
Put selling to generate income
When you sell a put option as an income generating strategy, this means your strategy is to never get assigned any shares. This approach is a little more advanced and it allows traders to safely make a return of around 2%-4% per month without any of the risks associated with stock ownership. Risk management is at the core of this strategy. Once you open a position and your trade goes against you, the safest thing to do is to close the position at a loss and open a new trade.
There are some positives and negatives to each of these Put selling strategies.
Risk and reward of each Put selling strategy
Again, selling put options to generate income is a slightly less risky approach because you are automatically risking less capital. In our PayPal example you would need about $6700 to purchase those shares in case of assignment; consider that if PayPal shares drop 20% or more from the time of your purchase, you’d be down big on your position and might be forced to hold the shares longer than you would’ve wanted to.
Put selling in the hopes of gaining a better stock entry might have downside risk which means the stock might go down even more before it goes back up, but I would describe the risk of put selling for income generation as being the complete opposite, consider that since you never own the shares you always run the risk of missing out on the upside potential of the stock.
Both worst case outcomes for each strategy are okay in my opinion. There is some level of risk with every option trading strategy, the objective is to understand and manage those risks.
Research and prepare
Consider that if you’ve done your research and have determined that a company’s shares are significantly undervalued relative to its fair value, you shouldn’t blink if the stock drops below your entry point. It might even be a perfect opportunity to purchase more shares.
Once the market recognizes the price mismatch that company’s shares have the potential to rally 30% or more. Those returns would far outweigh the 2%-4% return you would’ve been making from your income-generating strategy.
The key is to do a good fundamental analysis of all the stocks you trade, and, if you determine that you were wrong in your assessment of the value of the company, don’t be afraid to cut your losses and move on.
My goal with this article is to have Cash-Secured Puts explained in a way that can be actionable shortly after reading this article. This strategy can be a powerful tool for investors seeking income generation and the opportunity to acquire stocks at a discounted price.
By understanding this concept, and its advantages, plus the risks associated with this options trading strategy, anyone can be successful and make informed decisions aligned with their financial goals and risk tolerance.
If you liked this post, check out our post on covered calls to learn more ways to make additional income from your stocks.