What is a Cash-Secured Put and How Does it Work?
The next options strategy that you should considered after covered calls is the cash-secured put. These have miniscule more risk than a covered call, but remain on the very safe side of the option spectrum. Cash-secured puts are another option strategy that at first sounds intimidating, but is a simple way to boost your portfolio performance when applied methodically.
Quick Summary:
Introduce the option strategy of ‘cash-secured puts’ and how they can help you squeeze extra cashflow
Logical fallacies are one of the biggest drivers of underperformance and you can get paid to control them by incorporating these puts
The risks of cash-secured puts and an example
How to Use Options to Improve Your Returns
This post assumes you have familiarity to the basics of options. At some future point I can do an introduction to calls and puts for you, but that is not the purpose of this article.
Let’s get this out of the way upfront, stock options are slightly more complicated than regular stock trades and you can take very big risks on with them. However, the big risks tend to be when you hold naked options on a position. Options can absolutely be used to make your portfolio less risky when done correctly.
Put Options tend to confuse people more than call options. However, selling put options and collecting premiums is a great way to leverage your dollar-cost averaging (DCA) for extra cash. It also can be used to get some cashflow off stocks you like.
What Are Cash-Secured Puts?
First, lets discuss a put option in general. A put option give the purchaser the option to sell the underlying stock at the contract strike price at maturity. Therefore, when you buy a put option, you are doing it in case the stock price drops below the strike price.
Put Option Background
For example. A stock is at $100, you think it is worth $50, you buy a put option with a $90 strike and you get to sell the stock at $90 at maturity. If the stock drops to $50 at maturity, your make $40 on the option. If the the stock is still $100, it expires and you make $0.
In real life, your broker will cash settle for you and just send you $40. In theory, you are buying the stock on the market at $50 and immediately selling it to your counterparty at $90 netting the $40 difference.
Therefore, buying puts is a strategy used to hedge against price declines. Investors are generally risk-averse, so the premiums on put options tend to be fairly large. This leads to most protective put strategies underperforming over the long-term. For example, imagine buying 1% of your portfolio in puts over any period 2018-2021 and each time the market went up and you lost that 1%. This is a lot of return you gave away.
Cash-Secured Put Background
A cash-secured put is when you sell a put to collect that juicy premium from risk aversion, while holding enough cash to purchase the stock if the price is below the strike at maturity. By holding enough cash to cover your option position, you avoid any leverage or margin. Additionally it is a natural risk-control as you can’t sell more cash-secured puts than cash in your portfolio helping to prevent those stories of option trading causing bankruptcy.
Selling an option is taking a 'short’ position in the option. Similarly, put options are a ‘short’ position on the underlying. So being short an option that is itself short the underlying stock is the equivalent of being long the underlying.
In other words, selling a put is making a bet that you think the underlying stock goes up.
When you sell a put you get a premium upfront and when the maturity date comes, there are 2 possible scenarios:
The price of the stock < strike price
The option is executed and you purchase the stock at the strike price
The price of the stock > strike price
The option expires and you just keep the premium with no further action
The risk in selling a put is that the underlying stock price tanks and you are on the hook paying the much higher strike price. Basically the opposite of the scenario above, where you pay $90 for a stock only worth $50 in the market. The following example may help in your understanding.
Cash-Secured Put Example
Your risk with a cash-secured put is the stock dropping. For example, if you sell a $5 strike put option on a stock priced $5.50 and the company goes bankrupt. You would still have to pay $500 for the 100 shares of the stock even though it is immediately worth $0. (remember, 1 option is for 100 shares of the underlying. So you need to multiply everything by 100)
Obviously, you don’t want to do that.
For cash-secured puts, you are holding cash to cover buying the security at the strike price, or $500 in the example below. When you sell the put for $25, you have a starting position of $525 in cash on day one ($500 cash + $25 premium). Looking at the net position column, you will see that $525 is also the max profit on the cash-secured put. That is because if the stock goes up, the option expires worthless and you keep the initial premium and your cash. There is no way to make more than $525, that is your entire upside.
However, if the stock goes down, you still pay $500 for 100 shares of a stock that are worth less than $500. The $25 premium you collected up front helps provide a little relief, but the net result of your cash secured put is still a lower overall net value than you started. Basically, if the stock price ends up below $4.75 you are net worse off from the cash-secured put position. (At $4.75, you paid $500 for $475 worth of stock for -$25, but you have the +$25 from the premium, netting to your break-even point of $0).
You do own the 100 shares of the stock if it gets put to you and you can sell it immediately or hold it.
This last point can use reiterating because it is important. If you get assigned the stock from the option (stock price < strike price), you get 100 shares of the stock. Therefore, unless you are going to immediately sell the underlying stock, you want to enter cash-secured puts on names you don’t mind holding.
Cash-Secured Put Takeaways
In the simple example above we can draw a few conclusions. As previously stated, if the stock goes up, the put expires worthless and you keep the $25 premium and your $500 cash for a net position of $525.
You have put your $500 at risk for a capped upside of $25. However, you maintain all the downside. If the stock price drops to $0, you still pay $500 for it, and your ending position is just the $25 premium you collected or a loss of $475 overall.
So why would you keep all the downside and give up all the upside?
Cash-Secured Puts to Dollar Cost Average (DCA)
I generally use a cash-secured put as a way to dollar-cost average (DCA) into a position. If there is a stock you like, you can buy a partial position in it. Then you sell some out-of-the-money puts at a price you would like to DCA in. Out-of-the-money means the strike price is below the current stock price. I prefer this to limit orders as I can get paid to wait for the stock to come down to my price point with puts.
In the example above, if I like the stock at $5.50, I will buy some shares. Then seeing a $25 premium on the 1 month $5 put, I can sell those. You effectively end up with a cost basis of $4.75 if you get put the shares ($5 - $0.25 premium).
In the case where the price drops below $5, you are DCA’ing in at a 10-14% lower price. (note- 10% if you use $5 as cost-basis or 13.6% if you use $4.75. I have seen it done both ways so use the one you prefer). If you use standing limit orders to DCA in now, and don’t watch the market all day, you are likely better off using puts to DCA in. Only caveat is if the price drops a lot before expiration then comes back. If the price drops to $3 at end of January and back to $5.50 by the 2/15 maturity, the put expired worthless, but a $5 limit order would have been executed.
Cash-Secured Puts to gain some Cashflow
What if the price is unchanged for the month at $5.50? You pocket $25 on a $500 cash position, or a 5% return for the month.
Similarly, if the price of the stock goes up, you end up with the same profit of $25. However, you do have some opportunity cost of not capturing any of the upside in the stock move despite being technically ‘long’ the stock. This is why I’ll buy at least a partial position or do something to have upside exposure. In the example above, if you buy 100 shares and the stock goes to the very high $20 a share you would have $2,000 or a +$1,500 gain. If you use cash-secured puts, you have a $25 gain. So I always take a little partial position in the stock just in case it moons.
A 5% monthly return may not seem like much, but that annualizes to 80% return on the year if you can roll it 12 times. (heuristic note - 6% monthly return is a double over the year due to compounding). You likely won’t be able to get an 80% annual return with this strategy in real-life due to having to find these options with high premiums and have them never be assigned. However, this strategy can add material positive results over time.
What are the Optimal Times to Use Cash-Secured Puts?
Selling a put is making a bet that the stock will go up. Therefore, you want to find stocks that are below their fair value. Cash-secured puts are ideal when the market has over extended to the downside. This is especially true if the move was quick and volatile.
The optimal times and places to look for using cash-secured puts are:
As part of a dollar-cost averaging strategy
After a one-time shock down to a stock driving volatility is high
To benefit from investors risk aversion or hedging requirements
Additionally, I really like 1 month calls for this strategy as they have relatively high theta decay and it is a short enough time frame that you can be nimble as the option expires soon.
I already touched on using cash-secured puts to DCA in place of limit orders. Similarly, if a stock has a big move down (especially if it is for a one time write off), that is a great time to write a put. Recent large price changes increase the volatility assumption in the option which lead to higher prices. Since we are selling the option to collect the premium, we want a higher price.
Lastly, the average investor is risk adverse and this leads to a skew in put prices being higher than formulas would say (see put-call parity for example). Additionally, around earnings calls and announcements put premiums tend to creep up as investors hedge the news. These can be great times to sell puts for big premiums.
Relatedly many funds need to buy puts to hedge for their strategies for corporate risk management. For example, there are times the premiums on puts for M&A deals are large as firms buy puts to hedge the downside of a leveraged M&A spread play.
[Note: The “greeks” of options are outside the scope of this post. But to quickly describe the 2 used here for people unfamiliar with them:
Theta = measure of the change in price of the option for a change in time. When an option is out-of-the-money, the price goes to zero much faster when you have less time to maturity. Faster theta decay is good for you the option seller.
Vega = measure of change in price of option for change in volatility. Although outside of academia and actual option traders/hedgers, I have rarely seen the term vega used. Usually it is just called volatility and the more volatile the underlying stock is, the higher the price of the option. ]
Behavioral Finance, Logical Fallacies, and Cash-Secured Puts
Fear of missing out (FOMO), over-trading, and shiny-object syndrome all hurt your performance.
Fear Of Missing Out (FOMO)
FOMO is when you see a stock price increase and see other investors profiting so you buy at a high price. Usually this is late in the rally after the stock is over-extended and the price decreases shortly after.
Instead of chasing a stock up, you can sell a far out-the-money put option usually (as the stocks volatility is likely high during the run). Receiving money today for selling a put helps alleviate the feeling of not having exposure. Additionally, just seeing the name in your portfolio helps you with FOMO. Lastly, if you sell a far out of the money put it means you aren’t going to buy the absolute top and worst case you own it below where it is trading today.
Over-trading hurts performance
Over-trading is the bias of feeling like you need to do something in your account, especially if there is cash sitting there un-invested. Admittedly, cash management is the biggest continual struggle for myself as I can feel inflation slowly decreasing my purchasing power.
Rolling short put positions over month-to-month gives me the allusion of trading often, but it is essentially like resetting the same limit orders over and over (and getting paid to do it). So you aren’t really ‘trading’ as much as keeping your positions up-to-date. Since overtrading consistently has been shown to lead to poor performance this is a good guy
Shiny, New-Object Syndrome & Portfolio Creep
Related to over-trading bias, is the shiny, new-object syndrome where you have cash and a new idea comes along so you invest in it. Since you don’t have conviction you eventually lose interest and the position just meanders along. If you have seen your portfolio balloon up over 20 positions you may have this.
If I read an enticing stock analysis from an author, instead of buying a new position that will sit in my account forever, I can sell a put. Since the option matures, you need to actively choose to keep your exposure on expiring options. Many times a month later I see the company listed in my transactions as an expired option and can’t remember why I liked the name. Since I am bored with this particular stock and I just don’t enter a new short put. This helps control increasing numbers of names in your portfolio.
Worse case, the name gets put to you and you can choose to just sell it or keep it. But you are no worse off than if you brought the name upfront.
Wrapping up: Introduction to Cash-Secured Puts
I always have open cash-secured puts in my portfolio. Receiving a few percents of the portfolio every month on your cash while potentially buying names I already like at lower prices is a great risk:reward in my opinion.
A few housekeeping items at the end:
Use limit orders on your options. Often options have wide bid-ask spreads, so if you use a market order you may get a much worse cost than you want. Even if I want the trade to execute immediately, I will use a limit at the listed price just in case
You are able to “buy to close” your cash-secured put position. For instance, if the underlying stock gets terrible news, you can unwind the position before maturity. But note, if the price is tanking, the option price is going to be a lot higher than you want.
Please make sure you contact your broker and have margin & leverage off your account if you are starting out. That will prevent you from selling more options than cash available.
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