What Is a Cash-Secured Put and How Does It Work?
Understand the cash-secured put: a defined options strategy for investors seeking income generation or strategic asset acquisition.
A cash-secured put is an options trading strategy that allows investors to generate income while potentially acquiring shares of a company at a desired price. This approach involves selling an option contract and holding a specific amount of cash as collateral. It appeals to those willing to buy a stock if its price falls, but who also wish to earn a return if the stock maintains its value or rises.
Understanding Put Options
A put option is a financial contract that grants the holder the right, but not the obligation, to sell an underlying asset at a predetermined strike price on or before a specified expiration date. This contract involves two parties: the buyer, who acquires the right, and the seller (also called the writer), who takes on the obligation. The buyer pays a premium to the seller for this right.
From the seller’s perspective, they are obligated to buy 100 shares of the underlying stock at the strike price if the option holder chooses to exercise their right to sell. This obligation exists regardless of the stock’s market price at the time of exercise.
The Cash Requirement
The “cash-secured” aspect of this strategy refers to the requirement that the investor selling the put option must set aside enough cash in their brokerage account to cover the potential purchase of the underlying stock. This cash acts as collateral, ensuring the seller can fulfill their obligation if the option is exercised. The amount of cash required is equal to the strike price of the put option multiplied by 100, as one options contract represents 100 shares. For example, if an investor sells a put option with a $50 strike price, they would need to hold $5,000 (50 100) in cash as collateral.
This specified amount of cash remains held in the brokerage account and cannot be used for other investments while the put option contract is open. This cash reserve ensures the investor has the funds readily available to purchase the shares if they are “put” to them, meaning the option buyer exercises their right to sell.
Mechanics of a Cash-Secured Put
The process of a cash-secured put begins when an investor sells a put option, agreeing to buy 100 shares of a specific stock at a predetermined strike price by a certain expiration date. Upon selling the put, the investor immediately receives a premium, which is credited to their brokerage account. This premium represents the maximum profit the seller can earn if the option expires worthless.
There are three possible outcomes for a cash-secured put at expiration. If the stock price remains above the strike price, the put option will expire worthless. In this scenario, the seller keeps the entire premium as profit, and no shares are purchased. Conversely, if the stock price falls below the strike price, the option is “in the money,” and the option buyer will likely exercise their right to sell. The seller is then obligated to buy 100 shares of the underlying stock at the strike price, using the cash previously set aside. The effective purchase price of the shares is the strike price minus the premium originally received. If the stock price is exactly at the strike price, the option typically expires worthless.
Important Considerations for Trading
Before engaging in cash-secured put trading, investors must ensure their brokerage account is approved for options trading. Most brokerages categorize options trading permissions into levels, with cash-secured puts often requiring at least a Level 1 or Level 2 approval. Requirements for approval vary among brokers, taking into account factors such as financial situation and trading experience.
Understanding “assignment” is important for put sellers. Assignment occurs when the option buyer exercises their right, obligating the seller to fulfill the contract by buying the underlying shares at the strike price. This obligation exists even if the market price of the stock has fallen significantly below the strike price. While American-style options can be assigned at any time before expiration, European-style options can only be exercised on the expiration date.
Monitoring the underlying stock’s price and the option’s value is important throughout the contract. Investors also have several exit strategies available before expiration. The most common method to close a cash-secured put position and release the collateralized cash is to buy back the put option that was initially sold. This action cancels the seller’s obligation and can be done at any time, potentially locking in a profit or cutting a loss.