by Fred Fuld III
For investors looking to boost their returns or acquire stocks at a discount, the cash-secured put strategy offers a compelling option. It involves selling (or “writing”) put options on a stock you’d be happy to own at a lower price, while also setting aside cash to buy the underlying shares if the option is exercised.
Here’s how it works:
- Selling the Put Option: You grant the put buyer the right, but not the obligation, to sell you a specific number of shares (usually 100) at a certain price (strike price) by a certain time (expiration date). In return, you receive a premium upfront.
- Cash Secured: To mitigate risk, you tie up enough cash in your account to cover the potential purchase of the stock at the strike price. This ensures you have the funds to fulfill your obligation if the buyer assigns (exercises) the put.
Here is an example:
XYZ stock is selling for $47 per share. You sell a put with a strike price of $45 for a price of $1. The one dollar price represents the price per share, so in essence, you are selling it for $100. Assume the put option expires in 30 days.
If the stock is above $45 at the end of 30 days, you get to keep the $100. If the stock is close to $45 as the expiration date approaches, the put would probably be selling for around five or ten cents a share, and at that point, you could buy back the put at a huge profit.
If the stock falls dramatically, for example to $43 per share, the put might get exercised and the owner of the put could “put it to you”. That means you would be forced to buy the stock at $45 (higher than the current market price, but at least it would be lower than then $47 at the beginning of the transaction), but you still get to keep the $100 premium.
However, the alternative would have been if you had bought 100 shares of the stock for $47 a share instead, you would have been worse off.
Potential Benefits:
- Income Generation: Even if the stock price stays above the strike price by expiration, you keep the premium as income. This can be a great way to generate additional returns on your portfolio, especially in a flat or slightly down market.
- Discount on Stock Purchase: If the stock price falls below the strike price by expiration, the put option will be exercised, and you’ll be assigned the shares. This allows you to buy the stock at a lower price.
Investor Considerations:
- Stock Selection: Choose stocks you’re fundamentally bullish on and would be comfortable owning long-term,even if assigned the shares.
- Strike Price: Select a strike price slightly below the current market price. This balances the potential for assignment with the premium earned.
- Expiration Timing: Consider a longer expiration period to allow for potential stock price recovery and maximize premium income. However, this also increases the risk of assignment.
Understanding the Risks:
- Stock Price Decline: If the stock price falls significantly, you’ll be forced to buy shares at a higher cost than the current market value.
- Missed Opportunity: If the stock price rises sharply, you’ll only profit from the premium received, missing out on the potential for greater gains.
- Early Assignment: The put buyer can exercise the option before expiration, potentially forcing you to buy the stock sooner than anticipated.
Cash-secured puts are a versatile strategy for income-oriented investors or those looking to acquire stocks at a discount. However, careful planning and a strong understanding of options basics are crucial for successful implementation.
