Do you know how you could potentially earn a little cash just for agreeing to buy a stock you already wanted to own? In the world of options trading, this is possible with a strategy known as the cash-secured put.
What is a cash-secured put?
A cash-secured put—also known as a cash-covered put—involves having enough money in your account to cover the cost of potentially buying an underlying stock that you sell a put on.
Let’s break down each part of this strategy so you can fully understand what’s going on here. First, you need to know what a put option is. The buyer of a put has the right to sell a stock at a set price until the contract expires, and the seller of a put has the obligation to potentially buy a stock at a set price (i.e., the strike price) until the contract expires. The seller receives a payment from the buyer called a premium.
Note: The terms option buyer and seller can get a little confusing. It may help to keep in mind who is buying and who is selling the options contract (and not necessarily the underlying asset). Remember that an option buyer and seller are on the opposite sides of the same contract. In the case of a put, the buyer’s side of the contract allows them to sell shares of the underlying stock or ETF at the strike price to the trader who was on the selling side of the contract. This means the trader on the selling side could be obligated to buy shares from the put buyer if exercised. If this still seems a bit technical, don’t worry, we’ll unpack it more.
How does a cash-secured put work?
Before looking at an example to illustrate a cash secured put, here is the key thing to know: If the current stock price stays above the strike price until the put option expires and the buyer does not exercise the option, the options seller does not have to purchase the asset and simply keeps the premium. If the underlying stock price falls below the strike price, the option buyer may exercise the put, requiring the put seller to pay the strike price to buy the shares. This is true whether the market price is just below the strike price or significantly below it. In other words, no matter how much value the security has lost, you still must pay the strike price in the case of being a put seller.
An example of a cash-covered put
Okay, let’s say you are interested in buying shares of Company XYZ, which is currently trading for $55 a share. You like Company XYZ’s longer-term potential but would like to pay some amount less than $55 per share, and you also do not think it will fall substantially lower.
In the options chain, you can find prices at which buyers and sellers are willing to buy and sell puts at a variety of strike prices. Suppose you would be interested in buying 100 shares of XYZ company if the stock price fell to $50, but would also like to take in some current income. You decided that a cash secured put may help you achieve these objectives, so you set aside the value of that potential transaction, which is $5,000 (the $50 per-share price multiplied by 100 shares).
You decide to sell 1 put options contract (which controls 100 shares) of Company XYZ stock with a $50 strike price, expiring in 1 month. For selling the put, you receive a premium of $2.30 a share, taking in $230 ($2.30 a share times 100 shares controlled by the 1 contract).
Now with the trade in place (and you’ve set aside the amount needed to cover the purchase of the shares if the put is exercised), let’s look at some outcomes given changes in the price of the underlying stocks. If Company XYZ’s value stays the same or rises over the next month, you won’t be able to buy the 100 shares through exercising the options contract. That means you missed out on the short-term profit and can decide if you want to buy the shares outside at the higher price. Remember, you generated income from selling the put, so you’ve made $230 on this trade.
What happens if the underlying stock price declines? This should be a stock that you actually want to buy, so a short-term decrease in the price may be what you ultimately want. Of course, it depends on how much. Suppose XYZ stock declines to $49.99 by the expiration date. If the put is exercised, you will purchase the stock for $5,000 (100 shares times $50). And remember, you still took in the $230 at the outset of the trade. So, instead of buying the stock originally for $5,500 (the original $55 stock price times 100 shares), you have bought the same number of shares for $4,770 ($5,000 less the $230 premium).
But recall that you may be required to buy the shares at $50 no matter how much the stock price falls. What if the shares fell dramatically in value (perhaps due to some significant company news) to $35 per share? If the put is exercised, you would still be required to buy the shares at $50.
It should be clear that $47.70 is your breakeven price. The breakeven calculation for selling cash secured puts is strike price minus premium received. If XYZ’s price falls below $47.70, you are buying the stock for more than it is currently worth and have lost money on the deal. For example, if Company XYZ fell to $45 a share, you lost $270 in value (the $5 difference between $50 and $45 multiplied by 100 shares, minus the $230 premium). In the unlikely event that XYZ completely crashed to $0, that would cost you $4,770 ($5,000 for the 100 shares minus the $230 premium).
Advantages of cash-secured puts
Cash-secured puts come with a couple of main benefits:
- You receive income regardless of whether the option is exercised
One of the benefits of a cash-secured put is that, as the options writer, you receive a premium payment regardless of whether the underlying asset’s price rises, falls, or stays the same.
- You may be able to buy a stock below the current price
If the option buyer exercises the contract (meaning you must buy the stock at the strike price), you will be purchasing it for a lower price than it was trading at when you agreed to the contract. This can make cash-covered puts an appealing way for some investors to buy a stock they wanted to own anyway if they think the value of the security will rise in the long term.
In some ways, cash-secured puts may sound like limit orders, a type of instruction that stops a trade from going through if an investment’s market price isn’t at a certain amount or better. But unlike limits, cash-secured puts provide you with income regardless of whether the trade goes through. And if the trade does go through, you may get it at a lower total cost than what it would have originally cost.
Disadvantages of cash-secured puts
Before considering a cash-covered put, it’s important to understand the potential risks, including:
- You may lose money
Cash-covered puts have a similar risk of loss as owning stock: If you buy stock, it can lose value over time. It’s possible for the price of the underlying stock to go to $0. While this means you’d lose your entire investment if you owned the stock, you’d still be out a similar amount less the premium you received—if the put buyer exercised a contract when the stock’s value had bottomed out.
- Your potential profit may be limited
Because the underlying security has to drop below the strike price for the writer of a cash-secured put to buy the security, cash-secured puts have an inherent risk of limited profit. If the stocks price rises, you’ll only get to profit from the premium you received, and you may experience the opportunity cost of missing the chance to buy the stock.
How to sell cash-secured puts
If you’d like to sell cash-secured puts, here are some steps that you could follow.
1. Open/fund a brokerage account and get approved to trade options
If you don’t already have a brokerage account, consider looking for one with low fees and research capabilities that you find easy to use. Once you’ve opened an account, transfer money into it so you’ll have funds to cover any cash-covered put contracts you want to enter into.
2. Apply to trade options, if necessary
Depending on your brokerage, you may have to apply to trade options. At Fidelity, this involves completing an application about your finances, as well as your investing experience.
3. Research investment options and start selling cash-secured puts
If you don’t already know which stocks or ETFs you might want to sell cash-covered puts for, you can use your brokerage’s resources to identify potential candidates. Then log into your brokerage account, access the option chain, and enter the ticker symbol. The option chain lets you filter to potentially view several strikes, expirations, quotes of the options, and option strategy views. It will provide the ability to trade right from the option chain. If you trade at Fidelity, we have an Option Strategy Builder too to help you build and place an options trade.
