Cash-Secured Put: The Step-By-Step Guide by Eli Inkrot, Sure Dividend
In a previous article I provided a “step-by-step” guide for learning more about selling covered calls.
If you haven’t yet read that piece I’d recommending taking a moment to do so. In either event I’ll provide a quick refresher. It can be helpful to have this background in mind because a cash-secured put shares many of the same characteristics as the covered call.
Selling a covered call means that you own a security (in increments of 100 shares) and then make an agreement to sell your shares at a certain price in the future. For instance if you owned 100 shares of Coca-Cola (KO) at a price of $45, you could sell a January 20th 2017 call option with a strike price of say $50. This means that you’re willing to sell 100 shares of Coca-Cola at a price of $50 anytime between now and the next 10 months.
The benefit of making this agreement is that you receive an upfront premium. You can moderately or significantly increase your cash flow instead of solely relying on dividend income.
The downside is that if the share price rises dramatically, you could spend extra time and effort only to “cap” your eventual gains.
It’s important to be content with either side of the agreement. You want to be happy whether or not the option happens to be exercised. This sounds simple enough, but it takes a bit of thought before you make the agreement.
The same basic notion applies to selling a cash-secured put; you want to be content with either side of the agreement.
The advantages and disadvantages are very similar. With that in mind, let’s work through the basics of a cash-secured put.
What Is A Cash-Secured Put?
That’s a good place to start. A put option gives the buyer the right, but not the obligation, to sell 100 shares of a company at a given price in the future.
Source: Option Monster
Let’s say that someone holds 100 shares of Coca-Cola and they’re worried that shares may go much lower for whatever reason.
This person could buy a put option with a strike price of say $40. This now gives the buyer the right to sell at $40 per share anytime between now and the expiration date.
If the share price remains above $40, the put option will expire worthless. (Why exercise your right to sell at $40, if you can sell on the market for say $45?) Instead of exercising the option, the buyer would allow the option to expire and instead sell shares in the open market if they wanted to do so. In this scenario the put option is said to be “out of the money”.
Alternatively, if Coca-Cola’s share price goes below $40, the put option is now said to be “in the money”. In this case, the put option is valuable because it gives the buyer the right to sell at $40 when shares may be trading in the market at say $35.
Buying A Put Option Can Be Either Cautious or Speculative
If you own shares in a company and buy a put option, it’s effectively like buying insurance on your shares – no different than buying house insurance, as an example.
If the share price remains above your strike price, the option expires worthless. Alternatively, if the share price goes below the strike price you have now “capped” your downside. While the value of your shares would be declining, the value of your put option would be increasing.
Buying put options can be speculative if you do so without owning the underlying security. In this case it’s sort of like buying house insurance on a neighbor’s house. You would be betting on the share price to go down (or the house to get damaged). If the share price stays the same or goes up, your put option is worthless. If the share price goes down, the put option can become more valuable.
Buying put options can be either cautious or speculative. Put options are an “all or nothing” situation. Either the option is worthless or it pays out. For speculation this makes returns quite volatile. For “insurance” purposes, it can eat into the income you receive from a security but it may pay out later on.
That’s on the buying side…
What I’d like to talk about for the remainder of this article is selling a cash-secured put.
The reason that it’s called “cash-secured” is because you set aside the cash needed to buy shares to begin. So if you sold a put option with a $40 strike price, you would need to set aside $4,000 in order to make that agreement.
The put seller is on the opposite end of the transaction. I don’t want to take this analogy too far because there’s some important differences, but it’s sort of like you’re the insurance company. Selling a put option is making an agreement to buy 100 shares of security at a given price.
We’ll continue with Coca-Cola before providing a real world example with a different company.
Let’s say that you sell a put option on Coca-Cola with a $40 strike price. In this case you need to set aside $4,000 to buy 100 shares anytime between now and the option’s expiration date. If the share price remains above $40, the option would not be exercised and your $4,000 would be “released” – free to be allocated again as you see fit. If the share price goes to $40 or below, the option will be exercised and you’ll trade that $4,000 for 100 shares of Coca-Cola.
Now, why would anyone make this agreement?
Great question, I’m glad you asked. There are two basic reasons.
The first is that you get paid for doing so. The upfront cash flow is known as an option premium (which may be taxed at different rates than long-term capital gains, depending upon a few factors).
The second reason is that you’re happy to own shares, but you’d rather do so at a lower cost basis. Selling a put option allows you to get paid for expressing this sentiment. Maybe your art teacher was right: it pays to express yourself.
An alternative to selling a put option is setting a limit order to buy 100 shares of Coca-Cola at a price of $40 per share. This has the same basic goal – owning shares of Coca-Cola at $40 a share – but you don’t get paid for doing it this way.
Note: There is one advantage of the limit order, which I’ll detail later on, but that’s the simple reason for why someone might consider selling put options instead of setting up limit orders.
A Current Example Of A Cash-Secured Put
Coca-Cola works well as a demonstration, but I like to use a few securities to really outline the process. For this “real life” example of how you might think about selling a cash-secured put we’ll use Deere & Co. (DE).
Although the company operates in the agriculture, turf, construction, forestry and financial segments, you probably know the company best for its