Cash Secured Puts – A deep dive

Content

• Introduction
• Definition – What is a Cash Secured Put
• Mechanics of the strategy
• Benefits of the strategy
• Scenario and practical example
• Trader’s tips and considerations
• Conclusion

1. Introduction

Options trading offers a variety of strategies, each with its unique set of advantages. Among these, the “Cash Secured Put” or often abbreviated CSP stands out as a powerful tool for both income generation and potential stock acquisition at a discounted price. In this chapter, I will delve into the mechanics, benefits, and practical applications of this popular strategy. This is a great strategy for all levels of investors and option traders.

2. Definition & Objective – What is a Cash Secured Put?

A cash secured put involves selling a put option with the intention of either to:

• Earn the premium as an income, especially when you are bullish on the stock
• Acquire the selected stock at a lower price

The reason The “cash secured” part means you have set aside the necessary cash to purchase the stock, if it drops under the strike price and you’re assigned.

Essentially, you’re showing commitment to buying the stock if the option is exercised. (As a reminder : a put option is a contract that gives the holder the right to sell the underlying asset at the strike price on or before the expiration date).

3. Mechanics of the Strategy

4. Benefits of the Cash Secured Put Strategy

• Premium Income: Even if you never acquire the stock, continuously selling put options can provide a steady stream of income through the collected premiums.
• Potential Discounted Stock Purchase: If the stock price drops and you’re assigned, you effectively purchase the stock at a discount (strike price minus the received premium).
• Lower Risk: Compared to other trading strategies, the cash secured put involves a predefined risk. You know in advance the potential cost (if assigned) and the income (premium received).

5. Scenario and practical example

Let’s say have $ 15,000 in your cash account and you’re interested in stock Alphabet Inc (Ticker: GOOGL), currently trading at $135.54 for the long term.

You believe it’s definitely a good buy at $125. You sell a 3 week put option with a strike price of $125 and receive a premium of $162 ($1.62 per share).

Selling this put, actually means that the buyer of the option will pay you immediately a premium of $162 for you to be ready to buy the shares at $125 if the option will go below the strike price of $125 in 19 days, and if that doesn’t happen the contract expires and you keep $162 in your pocket.

Scenario 1: The stock remains above $125. The option expires worthless, which is perfect if your objective was to earn the premium. Your profit is the $162 premium, which is the maximum profit.

Scenario 2: Imagine the stock drops to $120 on the expiration date. You’re assigned and you buy the stock at $125 (the strike price). However, since you received a $162 premium, your effective purchase price is $123.38 per share, which is about $12 better than the current market price.

6. Trader’s Tips and Considerations

• Risks :
  • The share price can fall deeper below the strike price and the option is exercised. In that case you will have to buy the shares at a higher price that the market price of the shares, leaving you with a stock position with a momentarily negative return.
  • If you have really the intention to acquire the stock because you are very bullish on the stock, selling a CSP first may result in the share price never reaching the strike price and never getting assigned. The decision rests with every trader whether purchasing the stock directly is a preferable option compared to initiating a CSP first, especially if they aim to realize a specific profit potential they’ve envisioned.
  • Always keep in mind that when you need to buy the stock you will have broker’s fees to pay for the acquisition of the stock.
  • Always consider the delta of the sold option, which can be considered as an indicator of the option expiring out of the money. In the example (see yellow indications) above the option has a delta of -0,19 indicating a 19% change of expiring in the money and being assigned or a 81% chance for the option expiring out of the money and expiring worthless.

• Risk management :
  • Ensure you have the necessary cash to buy the stock if assigned. Never sell puts on stocks you don’t want to own, unless you are willing to settle for a loss immediately (in that case you are trading the naked options strategy and you may need to close the position by buying back the option at a higher price).
  • As a seller you are in control of the risk by opening because you select the strike price and the expiration
    • strike prices closer to the share price have an increased possibility of assignment, the benefit is that the premiums are juicier.
  • Selecting a stock and a moment of higher implied volatility (IVR) will also give higher premiums but evidently also large share price fluctuations. The implied volatility concept and the impact of it on option prices is one of the aspects that beginning traders must learn and experience.

• Monitor the price evolution :
  • Always keep an eye on the underlying stock and any news that might impact its price, just to be sure you are on top of the outcome of your position
  • If you are trading CSPs for cashflow than :
    • ideally the share price rises or at least stay above the strike price, then the option expires worthless;
    • if the share price spikes up or we are getting closer to expiration, you can even consider closing the option early as its value will have decreased a lot. You can create your own managing rule for this (for example > 80% of max profit)
    • if the share price drops below the strike price, and the expiration is coming closer, you can always extend the duration of the option position by “rolling the position to a later expiration date“. This may be an unfamiliar concept to beginning option traders at first but it refers to the process of repurchasing a previously sold option and subsequently selling a new option with a later expiration date. If you do this at a moment that the share price hasn’t dropped too much, it is even possible to roll out the position for an extra credit while extending the contract duration.

• Diversification: Consider diversifying by selling puts on different stocks in various sectors.

• Learning: the process of selling CSPs is ideal for beginning option traders because :
  • it introduces traders to essential concepts like strike prices, expiration dates, and premiums
  • it instills discipline as traders must have the necessary cash on hand, reinforcing the importance of capital management
  • it gives the opportunity by monitoring how the option performs relative to the underlying stock, allowing to gain insight into intrinsic and extrinsic values, volatility impacts, and time decay – all crucial facets of options trading.
  • as a beginning option trader, you can try different lengths of expiration to get a feel for the behaviour of option prices.

7. Conclusion

The Cash Secured Put is a versatile strategy that can serve both as an income generator and a method to acquire stocks at a discount. This strategy is very useful for beginning investors who want wants to own a specific stock and are looking to open a new position. Like all strategies, it requires understanding, practice, and risk management. Whether you’re a seasoned trader or just starting out, this strategy can be a valuable addition to your trading toolkit.

In essence, selling cash-secured puts provides a hands-on, yet controlled introduction to the dynamic world of options, laying a solid foundation for more complex strategies in the future.

This page provides a comprehensive understanding of the Cash Secured Put strategy, but it’s essential to remember that all investment strategies come with risks. Always do your research and consider consulting with financial advisors before making investment decisions. See the disclaimer.

I am sure this was useful, and in case you are new to option trading and want to learn more about options, I can suggest following content:

• Basic Option Trading Transactions
• Introduction to options trading – an attractive investment opportunity for all traders
• Covered Calls – A thorough examination

If you have any questions or comments, feel free to drop them in the comment section below or send me an email.

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