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Let me introduce you to the cash-secured put.
You select a stock you want, pick the price you want to buy it at, and then sell a put option contract with that strike price.
Doing that pays you a premium, which you get to keep even if the stock never hits that price.
That’s what’s so cool about this strategy.
You see, I could wait for Apple (AAPL) to drop down to $100 a share…
Or I could sell a put option on AAPL that expires in 30 days with a $100 strike price and collect a premium.
At the end of those 30 days, if AAPL stays above $100, I get to collect that premium. On the other hand, if AAPL goes below $100, I will be assigned (required to purchase) 100 shares of AAPL at $100.
But guess what?
I still get to keep that premium!
Let’s walk through the basics of cash-secured puts so you understand all the ins and outs.
Cash-Secured PutsA put option gives the owner the right to sell 100 shares of stock per contract to the option seller.
This means if the put option buyer exercises the contract, the option seller must buy 100 shares of stock at the strike price.
However, this right doesn’t come for free.
Like a covered call, a cash-secured put is the sale of an option, in this case a put contract, to receive a premium.
However, instead of owning stock against the position, as we would do with a covered call, we set aside enough cash to buy 100 shares of stock per option contract at the agreed strike price.
For example, let’s say I sell a put option with a strike price of $100 on AAPL that expires in 30 days, and I receive a $2 credit, or $2 x 100 = $200 in total, since each option contract controls 100 shares of stock. (I’ll have more details about that credit in just a minute.)
I would need to set aside enough cash to purchase 100 shares of AAPL at $100, or 100 x $100 = $10,000. That money is held by the broker until the option contract is closed or executed.
As long as the price of AAPL stays above $100, the owner of the put won’t want to execute the contract. If AAPL trades at $105, the owner of the put option is better off selling shares at the current market price rather than the option’s strike price of $100.
However, if AAPL drops below $100, then the owner of the put might be inclined to execute the contract. Let’s say AAPL drops to $90. The owner of the put contract would want to sell shares at the strike price of $100 to the person who sold the put option.
Here’s the thing. When you sell a put contract, you get paid a premium. That is the maximum profit you can make on the trade. You get to keep this money even if the option contract is exercised.
And that’s why many investors will use this strategy as a way to “get paid” while they wait for a stock to come down to their preferred entry level.
Here’s a payoff graph of what the trade looks like.
The blue line represents my profit or loss on the trade.
At $100 and above, I make my maximum potential profit, which is the $2 credit I received.
My breakeven point comes at $98, since I can use the $2 credit to offset the $2 price drop below $100.
After that, my losses grow as AAPL drops, the same as if I owned the shares outright.
Let’s look at another example, using a put option that is far below the stock’s current price.
I want to buy AAPL. However, I only want to buy it at $80, and let’s assume that it’s trading at $100.
I can sell put options for the $80 strike price and collect a credit while I wait for the price of AAPL to drop. If it never hits $80 by expiration, I still get to keep the credit I received to initiate the trade.
Now, I can also use this strategy to lower the price I pay to purchase a stock.
Assume that AAPL trades at $100 and I’m comfortable purchasing shares of AAPL at $100.
Rather than buying 100 shares of stock, I can sell an in-the-money put contract at a strike price of, say, $110. (“In-the-money” means that the stock is already trading below the strike price.)
If I get paid $11 to sell that put contract, that means I have $10 of intrinsic value and $1 of extrinsic value since $110 – $100 = $10 and $11 – $10 = $1.
Refresher: The intrinsic value of an option is the value of an option at expiration. For example, a call option with a strike price of $100 has an intrinsic value of $1 if the stock trades at $101.
Extrinsic value is all the remaining value in an option’s price once you remove intrinsic value. It’s the “time value” of an option, or theta. Using that same example, if the call option with a strike price of $100 trades for $7 and the stock trades at $105, the stock has $5 of intrinsic value and $2 of extrinsic value.
That extra $1 of extrinsic value is the time value of the stock that I get paid for selling the option.
And effectively, that lowers my purchase price from $100 to $99.
So, it’s a little something extra to sweeten the pot and help me make more from my investment.
Plus, if AAPL happens to rise above $110 by expiration, then the entire put contract expires worthless and I get to keep all $1,100 that I sold the put contract for ($11 x 100 shares of stock).
Here’s what the payoff graph would look like.
With the blue line representing my profit or loss, you can see how I achieve maximum profit at $110 and breakeven at $99. Once the stock falls below $99, I start to lose money, the same as if I bought the stock.
Let’s say I sold the put at $110 with 30 days to expiration.
To initiate the trade, I have to set aside $11,000 ($110 x 100 shares).
In the first scenario, where AAPL stays at $100, I make that extra $1 of extrinsic value (per share) for my troubles, or $100.
That equates to an annualized return of:
In the second scenario, where AAPL lands above $110 by expiration, I profit off both intrinsic and extrinsic value.
And that $1,100 profit equates to an annualized return of:
In that second scenario, if I had bought 100 shares of stock at $100 per share and been able to sell the stock within 30 days at $110 per share, I would still make that $1,000 off the intrinsic value (because of the change in the stock’s underlying price) but I wouldn’t make the $100 from the extrinsic value.
And remember, the maximum I can make on the cash-secured put trade is $1,100.
The maximum I could make from buying 100 shares of AAPL is only limited by how high the stock might go.
That’s the trade-off.
You cap your potential gains in return for a defined payment over a set amount of time.
Plus, if the stock is trading at $100 per share, it is more likely to see $99 a share than $110 a share.
Given the choice, would you prefer to sell cash-secured put options during a market sell-off or purchase a stock outright?
Let me know which you prefer and why.
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