Options may be notorious for their speculative use, but many investors use them to generate income or achieve other goals. For example, cash-secured puts provide you with an alternative way to delay stock purchases and buy stock below its current price. You earn a cash premium that you can keep whether or not the option is exercised.
Let’s take a closer look at how cash-secured put strategies work and whether they’re the right option to meet your investment goals.
What Are Cash-Secured Puts?
Cash-secured put strategies involve writing an at-the-money or out-of-the-money put option and simultaneously setting aside cash to buy the stock. While the strategy generates an immediate cash premium as income, most investors use cash-secured puts to acquire the stock below the current market price (e.g., during a temporary downturn).
Profit-Loss Diagram for Cash-Secured Puts – Source: Fidelity
For example, suppose that you short one 60 put option and set aside $6,000 in cash. You also receive an immediate $500 in premium income. If the stock price stays above the $60 strike price, you keep the $500 in premium income. If the stock falls below the strike price, you keep the $500 and acquire the stock at the $60 strike price.
The advantage of cash-secured puts is that the purchase price can be below the current price and you receive a cash premium regardless of whether the option is exercised. Of course, the disadvantage is that the profit potential is limited to the premium, and if the stock price rises sharply, you will receive only the premium income.
Risk-Reward Profile
Cash-secured puts have a unique risk-to-reward profile that you should be familiar with before using them. Like other put options, cash-secured put options have a negative delta, which means that they don’t move dollar-for-dollar with changes in the underlying price. In-the-money put options react more than out-of-the-money put options.
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The maximum profit is equal to the option premium received ($500 in the above example). On the other hand, the maximum loss is similar to owning the stock since you’re obligated to acquire the stock at the strike price ($60 in the above example), although these losses are partially offset by the premium. The breakeven price is the strike price minus the option premium.
Volatility has a neutral to slightly negative impact on cash-secured put strategies, although time decay has a positive impact on the strategy, assuming everything else remains equal. While there’s a slight assignment risk, depending on the strike price, most investors use the strategy to acquire stock, making assignment risk less important.
Using Cash-Secured Puts
Cash-secured puts involve relatively little management when you want to own the underlying stock. If the stock price is below the strike price at expiration, the put option will be assigned and you don’t need to do anything. You will buy the shares with the cash held in reserves, hence the name “cash-secured”.
If the stock price is above the strike price at expiration, then the put option expires worthless and the premium is kept as income. You must then decide if you want to buy the stock at the current market price, sell another put option or invest the cash somewhere else. The biggest risk is that you’d need to pay more to acquire the stock.
If you want to avoid assignment, you can roll cash-secured puts to kick obligations down the road. For example, you might enter a buy-to-close order for the original short put and simultaneously sell to open a put option further out in time and lower in price. In some cases, you can even realize a net credit from the roll if the new option is further out of the money.
It’s typically a good idea to roll out cash-secured puts across a short time frame before they go too far in-the-money. Put options that are too far in-the-money can be challenging to roll at a reasonable price, which means that you may be forced to take assignment. Preemptive rolls when the price is trending down can help mitigate these problems.
Cash-Secured Puts vs. Covered Calls
Cash-secured puts are often compared to covered calls since the two strategies share many similarities. For example, both strategies have a similar profit/loss diagram, and the stock selection process is nearly identical. Traders and investors use both strategies to generate an income from option premiums rather than speculating on future price movements.
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There are also several key differences:
- Cash-secured put writers typically wish to acquire the underlying stock at a lower price whereas covered call writers want to earn a premium on stock they own.
- Cash-secured put writers don’t collect any dividends—although they may receive greater premiums—whereas covered call writers collect dividends.
- Cash-secured put writers can only earn income from premiums whereas covered call writers can experience appreciation with out-of-the-money call options.
- Cash-secured put strategies may be restricted by some accounts, such as self-directed IRAs, whereas covered call writing is more common. However, these days, most brokers allow the sale of put options. Keep in mind, they may require a different trade level than covered calls.
In general, long-term investors looking to generate an income from their existing portfolio should use covered calls while those looking to add to their portfolio should consider cash-secured puts as a way to purchase stock at an attractive price while generating an income.
The Bottom Line
Cash-secured put strategies are a common way to acquire a stock below the current price while earning a cash premium. While they share some similarities with covered calls, there are several important differences to keep in mind. Cash-secured puts are primarily used to acquire stock rather than to generate income, although there are some exceptions.
The Snider Investment Method provides an easy-to-use strategy for investors seeking to generate income from covered call options and cash-secured puts. Take our free e-courses or inquire about our asset management services.