Getting paid while you wait, I like the sound of that.
A cash secured put is a conservative options strategy that can be used to purchase a stock for lower than the current price.
Let’s say you’re happy to buy AAPL at $173. You’re definitely going to be happy to buy it at $165.
Let’s work through an example.
A trader wants to buy APPL shares, but wants to wait for a minor pullback before getting involved. With the stock trading at $173.09, the trader wants to wait until it hits $165 before making a purchase.
Instead of waiting for a pullback (which may never come), the trade can sell a cash secured put with a strike price of $165.
The April 21st, $165 puts are currently trading for $3.20, so by selling this option the trader collects $320. He also has an obligation to buy AAPL at $165. It’s important to remember that even if the stock drops to $100 between now and April 21st, the trader still has to buy APPL for $165.
Let’s say AAPL does fall below $165 and the trader is assigned 100 shares. The total cost would be:
100 x 165 – 320 = $16,180.
This gives an effective purchase price of $161.80.
Not only do you need to be okay with purchasing the stock at this price, you need to have the money reserved to make the purchase.
Which Month Should You Sell?
In this example the trade was happy to buy AAPL for $165, but which month should he use? We used April in the example, but what if we chose a longer or shorter timeframe?
Option premiums will be more expensive the further out in time you go, but the rate of time decay will be slower and the annualized return will be lower.
Let’s compare April and November to illustrate the point.
The April put is trading for $3.20 and the November put is at $10.05
If AAPL stays above $165 and the puts expire worthless the returns will be as follows:
April $165 put – 1.94% or 11.06% annualized
November $165 put – 6.09% or 8.14% annualized
You can see that the return on the November put is higher on an absolute basis but lower on an annualized basis.
What Are the Risks?
Every strategy has its risks and this one is no different. There are two scenarios that create a downside in this strategy.
First, if the stock does not move lower but instead moves higher. If this happens you will not be assigned on the stock, which means you will not receive the shares that you wanted. As the stock moves higher, you will be left watching and missing out on the gains it could have provided.
If the stock makes a huge move higher, a cash secured put strategy will significantly underperform outright stock ownership. For this reason, cash secured puts are best used on stocks on which the trader has a neutral to slightly bullish outlook.
The second situation is having the stock move lower and then continue to move lower. In an ideal world, you would want to the stock to move to your strike price, get assigned the shares, and then have the stock take off higher. Unfortunately, things don’t always work out this way.
But, think about it this way, if you were happy to but APPL at $173.09, you are still better off because your cost basis is much lower at $161.80.
Also, remember that if you are assigned shares, you can continue to generate income from those shares in the form of dividends and selling covered calls.
If you are a long-term investor or just want to acquire stock at lower than the current price, cash secured puts can be a nice way to do that. They have several advantages if you can afford the time to wait and you get the added bonus of being paid while you wait to take ownership.
If you want to join me for an upcoming webinar, I’ll share exactly how I trade this and other options strategies.
* This article originally appeared on See It Market
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.