Cash-Secured Puts

Okay, let’s get the jargon out of the way.

A put is an options contract that allows the holder to sell a set number of shares, at a fixed price, within a certain period of time.

Now, if you are thinking that the definition sounds familiar, it’s because it’s virtually the same as for a call. I’ve simply swapped the word buy for sell.

A cash-secured put simply means that the seller has the requisite amount of money ring-fenced in their broker account to pay for the shares if required.

And selling a cash-secured put means that we are going to sell puts on shares that we would like to own. That will bring in premium, but we must ensure that we have the cash available to buy the shares if needs be.

And why would we do that?

Because it allows us the opportunity to pick up shares we like — for cheaper than they are currently trading at — whilst being paid for our obligation to do so.

Check out the following example.

Selling Juice

So, let’s say that we have done our research and decided that ABC Plc — a major supermarket — would be an excellent addition to our portfolio. The shares are trading at a fair price, have good fundamentals, and the chart looks good. It’s the sort of stock we’d be happy to own long term.

And, once we own it, we may also decide that we would like to sell covered calls against it.

It’s currently trading at a price that we are happy to pay, so we could march straight on in and buy a thousand shares. Perfect. Job done.

There is absolutely nothing wrong with doing that. You could then sit back and watch the dividends and covered call premium roll in.

Or, for no extra work, we could sell a put on ABC Plc instead.

We would be paid a premium for selling the put and we can select the price we wish to pay for the stock and the length of time we would like to honour the commitment for.

That’s the strike price and expiration date respectively.

With the shares currently trading at 250p, they have an impressive dividend yield of 4.5%.

ABC Plc is certainly a stock I’d be happy to own for the long term. Question is, how much would I be willing to pay?

Well, as we said, it looks pretty well priced at 250p. With the corresponding dividend yield I’d be happy to pay that.

Or, even better, what if we could pick it up for 240p — that would be even better.

And if we could get paid 5p a share whilst we waited — that would be fantastic.

Welcome to the world of cash-secured puts.

Getting Paid To Wait

My online broker shows that I can sell an ABC Plc 240p put with a month to run for 5p per share.

As with the calls, a single put represents 1,000 shares.

So, I am committing to paying £2,400 for a thousand ABC Plc shares if the put option is exercised in the next month.

The buyer of the put will pay me £50 for my commitment. That is mine to keep whatever the outcome of the trade.

A quick back of an envelope calculation tells me that if I repeat that trade throughout the year I would bring in £600 worth of premium.

At the strike price that’s an annualised yield of 25%. Not too shabby.

When you sell the put you are entering into a commitment that has two possible outcomes.

Either the share price is above 240p when the put expires or it drops below 240p.

If it stays above 240p, the put expires worthless. You keep the £50 premium and you are then free to sell another put at a strike price and expiration of your choosing.

That’s a pretty good source of income.

What If The Share Price Drops?

So, the obvious question is: What happens if the share price drops below 240p?

The simple answer is that the owner of the put is likely to exercise it. That means that you will be obligated to buy 1,000 ABC Plc shares for 240p each.

Is that a problem? Well it shouldn’t be. Remember that we analysed ABC Plc and decided that we would be happy to own their shares for the long term.

We were also happy to pay 250p each for them.

So, if you can now bag them for 240p and you have collected at least one premium payment in the process, that’s a pretty good deal.

As the proud owner of 1,000 ABC Plc shares you can also start to collect the dividend payments and sell covered calls on them if you wish.

However, the eagle eyed amongst you may have spotted the ‘risk’ with this strategy.

Where Is The Risk?

The buyer of the put has bought it for a reason. If the price of their shares drops below a certain level they want to ensure that they can sell them at a fixed price.

As the seller of this ‘insurance’ you have committed to pay 240p for the shares regardless of the price they are trading for when the put is exercised.

That sounds scary!

Well, it’s actually a lot less scary than simply buying the shares outright.

Let’s imagine you had bought the shares at 250p and that they then dropped to 220p over the next few months. You would be out of pocket by 30p per share. Not nice.

Now let’s imagine that instead you had sold three puts in succession as we described. The first two expired worthless and the third one was exercised.

After the drop to 220p, the owner of the put would certainly exercise it and you would be obligated to buy the shares at 240p each.

That’s a 20p drop. However, you have also been paid 15p for the three puts you sold and so can offset your paper loss with that premium.

That means that you are out of pocket by only 5p per share. That’s a whole lot better than the 30p loss if you had simply bought the shares outright.

And of course, you can go quite a while before one of your puts is exercised. All that premium adds up to provide a very nice downside buffer if it’s ever required.

So, as long as you actually want to own ABC Plc shares at some point, this is a great way to initiate a position.

You get to choose the price you wish to pay for the shares and then receive option premium whilst you wait to be exercised. When that day arrives, you simply flip the process round and start to sell covered calls against your newly acquired stock.

And of course — as an ABC Plc shareholder — there is always that 4.5% dividend to look forward to.