A lot of the discussion about options these days revolves around Yolo’ing into 0DTE options. But did you know that you can use options as a consistent way to generate income for your account? Previously we wrote about the Covered Call strategy of trading options. In this article, we are going to discuss the Covered Call’s forgotten cousin: the Cash-Secured Put. What is a Cash-Secured Put strategy? Read on to find out!
The Cash-Secured Put strategy is kind of the mirror opposite of the Covered Call strategy. Selling Cash-Secured Puts means you are betting that the price of the underlying asset will stay above a certain level. Like with Covered Calls, this is a strategy that is used to collect premiums to generate a consistent income stream.
If you’ve got five minutes to learn about Cash-Secured Puts then read on! We will try to break this strategy down to its simplest terms and explain the benefits and potential downfalls of selling Cash-Secured Puts in your brokerage account.
What is a Cash-Secured Put Strategy?
Let’s start with the basics: what does Cash-Secured Put even mean?
A Put Options contract is a financial derivative that gives the buyer the right, but not the obligation, to sell a certain number of shares at a given strike price by a given expiration date.
When buying a Put Option, it usually means you are bearish on the price of the underlying asset. You make a profit when the price of that asset falls lower.
But when you sell a Put Option, it is a bullish bet against the stock’s price falling below the strike price of the option. When you sell the Put Option there are two outcomes:
- You collect the premium and the option expires worthless
- You collect the premium and the price of the stock falls below the strike price
What happens in the second scenario? You will be assigned the shares of the stock but at a price that is lower than when you sold the option. Remember each option contract is a block of 100 shares.
This leads to the number one issue with selling Cash-Secured Puts.
What Happens When you get Assigned a Cash-Secured Put?
What happens when you get assigned these shares? Well, you have to buy them, hence the name Cash-Secured.
The number one issue with selling Cash-Secured Puts is that you need to have the money in your account. This can either be in the form of cash or margin. If you do not have the cash in your account then your brokerage can issue a margin call. This means if you do not sell those shares that you are assigned by the end of the day to cover the cost, the brokerage can and will do it for you.
If you do have the money, then the amount will be deducted from your balance. You will now own the number of shares that you sold options for.
Remember: you are targeting a strike price that you do not mind owning these shares for. If you get assigned these shares at a lower price, it works out in your favour. This is actually when the fun really begins.
What is the Wheel Strategy for Options?
Have you ever heard of the Wheel Strategy? It is a common strategy used by options traders to generate even more income for your account. Here are the three basic steps in the Wheel Strategy:
- Sell Cash-Secured Puts on a stock
- Get assigned those shares and own them
- Sell Covered Calls on those shares until they get assigned
The Wheel Strategy does require some capital in your account via cash or margin. But once this process gets going it can really become an income-generating monster.
Let’s take a look at an example of how this might play out.
Wheel Strategy Example with GOOGL Stock
For easy calculations, let’s use Alphabet (NASDAQ: GOOGL) stock. GOOGL is currently trading for about USD $100.00 per share.
In step one of this process, we would sell a Put Option on GOOGL with a strike price of $95.00 with a future expiration date. You can be as aggressive or as safe as you want with expiration dates. Further out will provide higher premiums.
So for the above contract, let’s say you made $100.00 in premium. You get to keep this premium no matter what happens at the expiration.
If GOOGL is above $95.00 at the expiration date, the contract expires worthless and you keep the $100.00.
If GOOGL is below $95.00 at the expiration date, you will be assigned 100 shares of GOOGL at $95.00 and still keep the $100.00 in the premium.
Not a bad deal, right?
So now what? You own 100 shares of GOOGL. Well, now you can sell Covered Call options. This means you are selling a Call Option with a strike price above or Out-of-the-Money.
Let’s sell a Call Option at the strike price of $100.00 again. Let’s say you earned another $100.00 in premiums for this call option.
If GOOGL is below $100.00 at the expiration date, the contract expires worthless and you keep the $100.00.
If GOOGL is above $100.00 at the expiration date, your 100 shares get assigned away and you still keep the $100.00 in premium.
Now what? You start the process all over again!
How Much Can You Make from the Wheel Strategy?
How much did you earn during this time?
Let’s start with $200.00 in premium. Now, this was a simplified example. You could sell GOOGL puts ten times before they get assigned. You could also sell Covered Calls on it ten times before getting assigned as well.
In this simplified example we earned $200.00 in premium. You also made $500.00 in capital gains from selling your $95.00 GOOGL shares for $100.00.
In three steps you made $700.00 minus any brokerage fees.
What are the Risks of Selling a Cash-Secured Put Strategy?
As with any investment strategy, there are risks with selling Cash-Secured Puts. First, as we mentioned, you need to have capital in your account. If you don’t, you can get a margin call and potentially a red flag against your account.
Another risk is that you can miss out on some upside. In the example above, let’s say the price of GOOGL stock actually jumped up to $105.00.
Since your Covered Call contract had a strike price of $100.00, this is what they would be assigned away at. If you had just owned the shares you would be up $1,000.00. So you missed out on $500.00 of upside.
This is certainly one risk with the Cash-Secured Put strategy. The trade-off for consistent premium income is that you do potentially miss out on major upside gains.
Let’s talk about what happens if you write or sell a put, and the stock keeps falling. In this case, the maximum capital you can make is the premium. It is possible that the stock can fall to zero by the expiration date. What does this mean?
For our GOOGL example, let’s say the stock price somehow fell to near zero. What would that mean for your put option?
Well, since you are obligated to buy the stock at the strike price, you would be on the hook to buy 100 shares of GOOGL for $95.00 per share. This is true even if the stock price falls to $94.00 or if it falls to $1.00.
So while your earnings are limited to $100.00 at first, your losses can be catastrophic. This is the most serious risk involved with selling put options.
Can I Close a Cash-Secured Put Option?
Yes! The beautiful part about options trading is that you can always get out of your position to minimize your losses. This is essential to know when you get into trading options.
When you sell a Cash-Secured Put, you are writing a new option. This means you are opening the option contract for someone to buy.
In other words, you Sell to Open.
But let’s say in our GOOGL example, the stock drops well below $95.00 and there is still time left to the expiration date.
You decide you do not want to buy GOOGL stock even at $95.00. Why? Because you think it will trade even lower in the weeks to come. Is there a way out of this Cash-Secured Put?
Yes!
With options, all you have to do is close out your position. This means if you sold a put option, you are buying it back, albeit at a loss.
When you want to close a Cash-Secured Put, you would select Buy to Close.
You will buy the same put option at the same strike price for the same expiration date. It will be more expensive since the underlying stock’s price is now much lower. But, it does save you from having to buy 100 shares of the stock.
Can I Roll Forward a Cash-Secured Put Option?
Yes! Rolling an option forward is essentially closing it out for this expiration, and selling another option for the same asset with a later expiration date.
You can also select a lower strike price as well if it pays you more premium. This helps if the underlying asset has a downward trend and you believe the price will continue to drop.
Rolling forward options is a great way to get out of a losing trade or if you want to avoid assignment.
What is a Naked Put Option?
Have you heard of a naked option? A naked put option is when you do not have the cash or margin to cover the cost of getting assigned shares.
Selling a naked put option is risky and many brokerages will not even allow you to do so.
If you sell a call option without owning the shares like you would for a Covered Call, then it is called a naked call.
We do not recommend selling naked put options unless you are an experienced trader. Even then, the risks probably outweigh the rewards.
Pros and Cons of Selling Cash-Secured Puts
Pros
- Earn a premium on every put option contract that you sell
- You get to buy stocks you like at a lower price if you get assigned
- Use the Wheel Strategy to sell covered calls if you get assigned
Cons
- The potential losses are large if the underlying stock continues to fall
- You need the cash or margin in your account in case you get assigned
- Not all brokerages allow you to sell put options, even if you have the cash
The Bottom Line: Selling Cash-Secured Put Options
Is this a strategy for everybody? Absolutely not. First of all, most brokerages require you to have extensive trading experience before they allow you to write options. Second, you usually need a substantial amount of capital or margin in your account.
If you are an experienced options trader, then selling Cash-Secured Put Options can be a great way to collect income on stocks you are already bullish on. You can take it one step further and employ the Wheel Strategy to continue collecting premiums even if you get assigned shares.
In the end, the decision to sell Cash-Secured Put Options should be made by you. Do some research, try the strategy in a practice account, and make sure you understand all of the risks involved.
Thanks for reading this, we hope it helped!
Stay savvy!