Options are often seen as speculative instruments for traders, but many investors use them to generate income. In fact, the most sophisticated option traders use them to reduce risk, limit downside and boost the income on a stock portfolio. While covered calls are the most popular income strategy, there are several others that investors should consider. Let’s take a look at how cash secured puts work and when you may want to consider using them to generate extra income in your portfolio.
What Are Cash Secured Puts?
Cash secured puts are created by writing, or selling, put options with cash set aside to purchase the underlying stock if the option is exercised. When writing the put option, the investor receives income from the option premium that they keep regardless of whether it’s exercised. If the option is exercised, the investor ends up owning the underlying stock at a lower price.
Cash Secured Put Profit-Loss Diagram – Source: Fidelity
There are three important price points to keep in mind:
- Maximum Profit: The maximum profit is limited to the net premium received when establishing the position.
- Maximum Loss: The maximum loss occurs when the stock price falls to zero—although that’s not a likely outcome.
- Breakeven Point: The breakeven point is equal to the strike price minus the premium received—effectively lowering the cost basis of the stock.
Time value and implied volatility both impact the price of the option. Time value decreases as the expiration date approaches, which is good news for the option writer since the option price will decline, all other factors being equal. If the stock becomes more volatile, implied volatility rises and the option price increases, which is bad news for the option writer if they want to close the position prior to expiration.
Cash Secured Put Strategies
Cash secured puts are often used to either acquire stock below the current price or earn income on cash deposits without taking a risk greater than owning stock.
Let’s take an example of each use case along with the pros and cons associated with them.
Acquisition Strategy
Suppose that you need to rebalance a stock in your portfolio following a significant decline in price. You may be hesitant to acquire the stock outright because the price remains in a downtrend. Cash secured puts enable you to generate an income by writing a put and either acquire the stock at a lower price or pocket the income and try again next month.
The biggest risk of using cash secured puts is that, if the stock price rises and the option expires, you may incur an opportunity cost. In other words, you may have to pay more to rebalance the position, although the premium income offsets a portion of that opportunity cost.
Income Strategy
Suppose that you want to generate an income using options and have a bullish outlook on a given stock. By establishing a cash secured put, you can collect the option premiums with the goal of the option expiring worthless. If the option is exercised, you end up owning a stock that you have a bullish outlook on at a lower price point.
The biggest risk of using cash secured puts as an income strategy is that, if the option is exercised, you end up having to acquire stock or pay to get out of the position. While the risk is limited to owning the stock, that may not be the ultimate goal for income investors.
Alternatives to Consider
There are several option strategies that investors can use to generate income, but investors should take the time to understand the pros and cons of each strategy before using them.
Snider Advisors specializes in helping investors use both covered calls and cash secured puts to generate an income from a long stock position. Through a specific set of rules, investors employ both option strategies to boost income and manage risk. With similar profit and loss profiles, the strategies can be used interchangeably.
Snider Advisors’ Unique Platform – Source: Snider Advisors
There are also several other strategies that offer different pros and cons:
- Collars: Collars involve selling an out-of-the-money covered call that’s paired with a purchasing a put as an insurance policy. Profits and losses are both limited with collars, which makes it a relatively safe strategy with limited reward and income capabilities.
- Spreads: Spreads involve purchasing one option and selling another. The combination can include different strike prices or expiration dates. Credit spreads can be used for income generation when the proceeds from selling the option exceed the purchase price of the other option leg. The opposite, debit spreads, are more often used for leverage and speculation.
- Iron Condor: The iron condor involves purchasing one put credit spread and one call credit spread. As a non-directional strategy, investors profit when the underlying stock has low volatility, making it a reliable way to generate income.
In addition to options, investors may also want to consider more conventional ways to generate income. Dividend stocks and fixed income investments are the two most common ways to generate an income, but real estate investments, master limited partnerships and other strategies are other ways to generate an income.
The Bottom Line
Cash secured puts enable investors to generate an income by writing a put option that’s backed by cash. In particular, it’s a great way for investors to automatically purchase shares if the price declines while also receiving a premium to do so. Investors interested in generating an income should use it as just one of many different potential strategies in their repertoire.