Cash-secured Puts (CSPs) are a versatile, bullish to neutral options trading strategy used to generate income, hedge portfolios, and even speculate on stock prices.
We’ll outline the basics of cash-secured puts, including how they work, the advantages and risks associated with them, and how to construct a CSP so you have a thorough understanding of how to incorporate cash-secured puts into your trading portfolio.
What are cash-secured puts?
A cash-secured Put (CSP) is an options trading strategy where you sell a put option on a stock or ETF to generate income (and potentially own the stock). You receive a credit for the value of the option’s premium when selling a put option.
However, you must have enough cash in your brokerage account to cover the cost of purchasing shares if the option is exercised. Remember - one option contract is equivalent to 100 shares of stock.
For example, assume a stock is trading at $110 per share, and you sell one put option with a $50 strike price for $5. You’ll receive a credit of $500 (1 contract x 100 shares x $5 premium). If the option is exercised, you would need $10,000 available in your account to buy the stock ($100 strike price x 100 shares).
How cash secured puts work
The mechanics of cash-secured puts are relatively straightforward. To execute a CSP strategy, select a stock you would be willing to own in the future. Sell one or more put options to generate an upfront premium payment from the buyer of the option.
At this point, it is important to remember that you are obligated to buy the stock if it is below the strike price at expiration or the option is assigned before expiration. This is why it is called “cash-secured” – because there is always enough cash available to cover any losses incurred due to exercising one or more put options.
Advantages of cash-secured puts
One of the major advantages of CSPs is that they offer investors a way to generate income from selling options. By selling put options on stocks they plan to own, investors can limit their downside risk and reduce the cost-basis of the stock if assigned.
In the example above, the $2 credit is applied to the stock’s purchase price if assigned. So, you would essentially own the stock at $43 ($45 strike price - $2 premium).
Another advantage of CSPs is that it offers investors more flexibility than traditional buy-and-hold strategies. Rather than simply buying stocks and holding them until they either appreciate or depreciate in value, investors can use CSPs to actively manage their positions and take advantage of market trends as they arise.
For example, if an investor sees a stock dropping in value but believes it will eventually rebound in price, they may choose to sell some put options rather than using a basic limit order, thus generating some income while waiting to buy stock.
Finally, CSPs also offer investors a way to speculate on stock prices without actually buying shares. By selling puts with strike prices lower than the current stock price, you can generate income by speculating on future movements and even make money even if the stock declines a little.
Risks of cash-secured puts
Despite its advantages over traditional buy-and-hold strategies, there are also some risks associated with using CSPs that should not be overlooked. The first risk relates directly back to being “cash-secured” – you must still have enough funds available to buy 100 shares per contract at the strike price.
Another risk associated with CSPs involves timing – since options have expiration dates, you must be careful not to let contracts expire in-the-money if you want to avoid owning the stock. This could result in buying back the option contract for more than you sold it, and you’ll realize a loss on the position.
Therefore, it is important to continually monitor positions and take action as needed prior to expiration.
Cash-secured puts can be an effective tool for generating a steady income from options trading – provided you take certain precautions when using them as part of their overall trading strategy.