What if you could buy stocks lower than the current market price? And what if you could make money when you’re wrong about the direction of the market? If either of those scenarios sounds appealing to you, then perhaps you should consider selling a cash-secured put.
When you sell a put option, you sell someone who has the right (but not the obligation) to sell you 100 shares of the underlying security at a specified price (strike price) before a specified date (expiry date). For the sale of this right to the buyer, the put seller receives a premium from the buyer.
This premium may be retained by the put seller, whatever happens, but there is a purchase obligation for the shares when the share price is equal to or below the strike price.
When to Sell Cash Secured Puts
You’re long-term bullish on a stock, but you don’t want to pay the current market price for it. In other words, if the stock dips, you wouldn’t mind buying it. You might consider entering a limit order at the price you’d like to pay for the shares. But selling a cash-secured put gives you another method of buying the stock below the current market price, with the added benefit of receiving the premium from the sale of the put.
How to Sell Cash Secured Puts
Sell an out-of-the-money put (strike price below the stock price). You may want to consider choosing the first strike price below the current trading price for the stock, because that will increase the probability the put will be assigned, and you’ll wind up acquiring the stock.
In order to receive a desirable premium, a time frame to shoot for when selling the put is anywhere from 30-45 days from expiration. This will enable you to take advantage of accelerating time decay on the option’s price as expiration approaches and hopefully provide enough premium to be worth your while. But what you consider a good return is up to you.
Once you’ve chosen your strike price and month of expiration, you’ll need to make sure there’s enough cash in your account to pay for the shares if the put is assigned (hence the term “cash-secured” puts).
Ideally, you want the stock price to dip slightly below the strike price, and stay there until expiration. That way, the buyer of your put will exercise it, you will be assigned, and you’ll be obligated to buy the stock. The premium received from selling the put can be applied to the cost of the shares, ultimately lowering the cost basis of the stock purchase.
Put-selling theoretical example
Imagine stock XYZ is trading at $52 per share, but you want to pay less than $50 per share for 100 shares. You sell one put contract with a strike price of $50, 45 days prior to expiration, and receive a premium of $1. Since one contract usually equals 100 shares, you receive $94.40 ($100 minus $5.60 commission).
If the put is assigned, you’ll be obligated to buy 100 shares of XYZ at $50. In order to be cash-secured, you’ll need at least $5000 in your account. Since you’ve already received $94.40 from the sale of the put, you only need to come up with the additional $4905.60 ($5000 minus $94.40).
How might this trade pan out?
Scenario 1: The Stock Dips Slightly Below
This is a great scenario. Let’s say the stock is at $49.75 at expiration. The put will be assigned, and you will buy 100 shares at $50 per share. However, since you already received a $1 per share premium for the sale of the put, it’s as if you paid net $49 per share. Since the stock is currently trading for $49.75, you achieved a savings of $75 before commissions ($0.75 x 100 shares). Huzzah.
Scenario 2: – Stock Rises
Now imagine the stock rises, and ends up at $54 at expiration. That means there’s some bad news, but there’s some good news too. The bad news is you were wrong about the short-term movement of the stock. Since it didn’t come down to the strike price, the put won’t be assigned and you won’t get the stock at $50 per share. If you had simply bought the stock at $52 instead of selling the put, you would have already made $2 per share: double the $1 premium you received.
On the other hand, you did receive a $1 premium, or $100 total for being wrong — even when you subtract out commissions, there’s nothing wrong with that. Plus, the cash you used to secure your put will be available to you for other trades. So there’s a silver lining to this otherwise cloudy trade.
Scenario 3: The Stock Dips Further Than You Anticipated
What if the stock is at $48 as the options expire? The put will be assigned and you will pay $50 per share. Subtracting the $1 put premium received (less commissions), it is as if you paid about $49 per share. You may be tempted to curse and think you overpaid for the stock by $1 per share.
But look at the bright side. If you hadn’t used this strategy, you might’ve simply entered a limit order at $50 and not even received the put premium. That would be worse, right? Plus, now that you own the stock, it might make a rebound. Let’s hope you’re a good long-term stock picker.
Scenario 4: The Stock Completely Tanks
This is obviously the worst-case scenario. Let’s hope your forecasting would never be this wrong. But what if the stock does completely tank? There are a couple of things you can do.
First, you can accept assignment and pay $50 per share, irrespective of current stock price. In this case, you’d be hoping your long-term forecast is correct, and the stock will bounce back significantly.
If you doubt the stock will make a recovery, your other choice is to close your position prior to expiration. That will remove any obligation you have to buy the stock. To close your position, simply buy back the 50-strike put. Keep in mind, the further the stock price goes down, the more expensive that will be.
This scenario demonstrates the importance of having a stop-loss plan in place. If the stock goes beneath the lowest point where you’re comfortable buying it, a stop order should be placed to buy back the 50-strike put. This is much the same concept as a stop order you might have on stocks in your portfolio.
Selling cash-secured puts is a substitute for placing a limit order on a stock you wish to own. You receive a premium for selling the puts, and if the options are assigned, the premium can be applied to the purchase of the stock and you can start selling covered calls.
If the stock doesn’t dip below the strike price by expiration, the puts will probably not be assigned, and you won’t have the opportunity to buy the stock at the strike price. However, the options will expire worthless and you’ll get to keep the premium. And that’s a good thing. Just remember, only sell puts on the number of shares you can reasonably afford to buy.