What Is a Cash-Covered Put and How Does It Work?

Options contracts grant a buyer the right, but not the obligation, to purchase or sell an underlying asset at a predetermined price by a specific expiration date. These contracts derive their value from an underlying asset, such as a stock, and are used by investors for income generation, speculation, and risk management. A cash-covered put is an options strategy that involves managing potential obligations.

Defining a Cash-Covered Put

A cash-covered put, also known as a cash-secured put, is an options strategy where an investor sells a put option and simultaneously sets aside enough cash to fulfill the obligation of buying the underlying shares if the option is exercised. This strategy differs from a “naked put” because the seller maintains sufficient capital to cover the full purchase price. The term “cash-covered” refers to having the necessary funds readily available in a brokerage account.

A put option gives its buyer the right to sell an underlying asset, such as shares of a stock, at a specified price. The seller of a put option assumes the obligation to buy that underlying asset at the agreed-upon price if the buyer exercises their right.

Key terms include the “strike price,” the fixed price at which the underlying asset would be bought or sold. The “expiration date” marks the final day the option contract is valid. The “premium” is the money the seller receives from the buyer for writing the option. The “underlying asset” refers to the specific security, such as a stock, on which the option contract is based.

The Mechanics of a Cash-Covered Put

Initiating a cash-covered put trade involves an investor selling a put option on an underlying asset. When selling this option, the investor specifies a strike price and an expiration date for the contract. Upon the sale of the put option, the investor receives a payment from the option buyer, known as the premium. This premium is the primary incentive for entering into this type of options trade.

A defining characteristic of a cash-covered put is the requirement for the seller to hold sufficient cash in their brokerage account. This cash must be equal to the total cost of purchasing the underlying shares at the strike price, should the option be exercised. For example, since one options contract represents 100 shares of the underlying stock, selling a put with a $50 strike price would require setting aside $5,000 ($50 x 100 shares) in cash. This collateral ensures the seller can meet their obligation.

During the period between trade initiation and expiration, the premium received by the seller is retained regardless of how the underlying stock’s price fluctuates. The investor monitors the market and prepares for potential assignment.

Potential Outcomes at Expiration

At the option’s expiration date, two scenarios can unfold, depending on the underlying stock’s market price relative to the put option’s strike price.

In the first scenario, the option expires worthless, also referred to as “out of the money.” This occurs if, at expiration, the underlying stock’s price is trading above the put option’s strike price. The buyer of the put option will not exercise their right to sell the shares at the lower strike price, because they can sell them for a higher price in the open market. The put seller retains the premium received, and the cash held as collateral in their account is released, becoming available for other investments.

The second scenario involves the option being exercised, or the seller being “assigned.” This happens if the underlying stock’s price is below the strike price at expiration. The put option buyer will exercise their right to sell the shares at the strike price. Consequently, the seller of the cash-covered put is obligated to purchase 100 shares of the underlying stock per contract at the predetermined strike price, utilizing the cash that was set aside. The premium originally received effectively reduces the net cost basis of the acquired shares. For instance, if shares are bought at a $50 strike after receiving a $2 premium, the effective purchase price per share is $48.

The motivation for employing a cash-covered put strategy is twofold: to generate income from the premium received or to acquire shares of a desired company at a lower effective price. Investors use this strategy when they are willing to own a stock at a specific price point. The premium earned provides a buffer against a moderate decline in the stock price, or it can be a source of income if the stock remains above the strike price.