Many new investors get intimidated by the trading of options, especially in the face of complex terms and strategies. They are in search of some source of income and risk-reducing tool but feel overwhelmed.
The cash-secured put is one of the easiest entry points to options trading. Selling put options, knowing that you have sufficient cash to purchase the underlying stock if called, is one strategy that allows for income generation and potential discount stock acquisition.
This guide will make cash-secured puts easy to understand by relating their mechanics, benefits, and risks through relatable examples and clear instructions. This will help you confidently utilize this strategy for enhancing your investment portfolio.
What is a Cash-Secured Put?
A cash-secured put is an options strategy where the investor sells put options while having sufficient cash on hand to buy the underlying stock in case the option gets exercised. Thus, if the price of the stock falls below the strike price, then the investor will be able to buy it at a discounted rate, else she keeps the premium for selling the put option.
Why Choose Cash-Secured Puts?
There are several reasons why cash-secured puts appeal to investors.
It gives you an immediate premium when selling a put. The income so generated can prove to be fairly predictable, especially during a stable or slightly bullish market scenario.
Discounted Stock Purchase: If the price of the stock falls below the strike price, then one gets to purchase it at a lower value than its present market price; hence, discount.
Limited Risk: Compare this to a naked stock buy. Here the worst that will happen is loss of the difference between the strike and the stock’s eventual value, less the premium taken in.
How Cash-Secured Puts Work
Let me explain better through an analogy
Suppose you wish to purchase a car for $40,000. A seller offers you the following deal: if you agree to wait for a month, they may sell you the car for $34,400. If they fail, they will pay you $2,000 for your waiting. Would you accept the offer? If you do, you are adopting the idea of a cash-secured put.
A cash-secured put works similarly in the stock market:
Example Stock Scenario: Suppose a stock is trading at $10 per share. You think it’s a good buy at this price but would like to buy it at $9. You sell a put option with a $9 strike price, agreeing to buy the stock at this price within a month if the stock drops to or below this level. In return, you receive a premium, say $0.50 per share. But, if the stock does not come down to below $9 dollars, you enjoy your premium without buying a stock.
Executing a Cash Secured Put – Step by Step
Choose A Stock: Choose some stock you may not mind to possess. Ensure the stock is of sound fundamentals that fits into the investment strategy and approach.
Set a Strike: Set a strike price below current market price where you are interested in buying stocks.
Sell the Put Option: You will sell the put option on the strike price and the expiration date chosen. Ensure that you have cash available in your account in case the put is exercised.
Track the Trade: Follow up on how the stock does. If, by expiration, it’s still above the strike, you keep the premium. But if it goes below, you may need to purchase at the strike price.
Real-Life Example: Sirius (SIRI)
Let’s put this strategy to work by using a real-life example with Sirius (SIRI), currently trading at $4.89 per share.
Scenario 1: SIRI stays above $4.50
You sell a put option with a $4.50 strike price for a $0.32 premium.
If SIRI stays above $4.50, you don’t buy the stock but keep the $0.32 premium per share.
Scenario 2: SIRI falls to $4.50 or below
If SIRI drops to $4.40, you buy the stock at $4.50. Factoring in the $0.32 premium, your effective purchase price is $4.18.
This provides a buffer, as your break-even point is lower than the current market price.
Scenario 3: SIRI plummets
If SIRI plummets to $1, you’re still obligated to buy at $4.50. Despite receiving the $0.32 premium, the substantial drop means a significant paper loss.
Pros and Cons of Cash-Secured Puts
Pros:
Income Generation: Regular premiums generate a steady income.
Potential Discounts: You get to buy the desired stocks at a reduced price.
Risk Mitigation: The strategy has less risk compared to buying the stock outright since the premium covers the potential losses.
Cons:
Capital Requirement: It requires substantial capital to acquire the put since you need to have cash on hand to buy the stock.
Limited Upside: When the stock price appreciates considerably, you miss out on those gains since you’re not holding the stock.
Downside Risk: When the stock price declines sharply, you still suffer losses, but this time a little bit mitigated by the premium.
Cash-secured puts is a great tool for generating income, buying stocks at discount, and making additional money off of the investment portfolio. You only learn how to take all this into consideration when you know what risks and rewards are involved. Before taking the options trading risk, one needs to ensure that he or she has the capital and knowledge. As with all other investments, due diligence is essential, and the investment portfolio should be aligned with all short-term and long-term financial goals.
