In this article we go into cash secured puts–a common way to generate income with put options with the possibility of purchasing shares below market price.
Cash Secured Puts
Definitions
- Put Option:
“A put option is a contract giving the owner the right, but not the obligation, to sell–or sell short–a specified amount of an underlying security at a pre-determined price within a specified time frame."
reference - https://www.investopedia.com/terms/p/putoption.asp
- Cash Secured Put:
“The cash-secured put involves writing a put option and simultaneously setting aside the cash to buy the stock if assigned."
reference - https://www.optionseducation.org/strategies/all-strategies/cash-secured-put
Introduction
Selling cash secured puts can earn extra passive income on stocks that you wouldn’t mind holding anyway while providing a discount from market price if you were to be assigned to buy the shares.
You set the strike price at a point that’s reasonable for you to buy at and obtain shares in addition to the profit from the premium.
The mechanics of a written option:
You pick an expiration date and a strike price.
You collateralize either stock (for calls) or cash (for puts) and get paid a premium for doing so.
If on the expiration date, the stock price is in the money (above call strike price or below put strike price) you will forfeit your collateral.
Is this a bad thing?
Ideally not because when you pick the strike price, you are picking the price you’re comfortable buying or selling at. You’re accepting the risk of giving up your shares if the price moves too much and are getting paid to take that risk.
And if the strike price doesn’t get hit?
Then the options you sold expire worthless and you collected premium for a worthless option.
Doing that over and over again will earn you more and more premium and effectively lower the total cost basis you paid for the whole position.
What if you change your outlook?
Sometimes you still don’t want to be forced to buy (for example if you thought it would go down by like 1% and it went down by 10%). In this situation you can buy the written option back and roll it out to a later date and/or roll it to a different strike price that you’re now comfortable selling at second time around.
Fidelity’s guide:
It’s also a good way to close a position with defined profits when Implied Volatility (IV) drops allowing you to buy back the position for less than you were paid earning a net profit.
Some people prefer to do this rather than waiting the full time for option expiration so they can lock in profits and remove the risks mentioned before.
Summary
Cash Secured Puts are a common way to generate income with put options while potentially receiving stocks at a discount to market price. Compared to other strategies, they are considered to be one of the more conservative approaches to generating income through options.
