How and why use a Cash Secured option
Did you know that you can make money on the purchasing of stock and exchange traded funds (ETF)? In this article I am going to discuss how this is done using the Cash Secured option strategy. I am going to typically mention stock, but this can be interpreted as stock or ETFs. In this strategy you can sell put options that obligate you to purchasing a stock if it declines below a specific price.
Please Note: I want to let all readers know that I am not a financial professional. This is a hobby/interest that will help me support myself through this difficult time of COVID-19 and help support me during retirement.
In this strategy you sell puts on stocks you are interested in and earn a premium for each option contract you trade. My goal with these trades is not to purchase the stock but to earn income selling the options. However, if I end up owning the security, I am ok with it. I typically invest in dividend paying securities that have a track record of increasing dividends and steady growth.
The reason the strategy is called Cash Secured option is because throughout the obligation period (the days on or before expiration), the needed cash for purchasing the stock must be maintained in the brokerage.
- Selling a put option
When you sell/write an option contract, you are obligated to buy the underlying security from the buyer of the option at the strike price up until the expiration date. You are assigned the security if the price goes below the strike price.
If you sell a put option, each contract covers 100 shares. 1 contract = 100 shares, 2 contracts = 200 shares, and so on.
- OTM Vs. ITM
When selling a Cash Secured option, you typically sell the option Out of The Money (OTM), meaning the strike price is lower than the current price of the stock. For instance, if XYZ stock price is $50 and the strike price for the put option is $45. If the stock price is equal to or more than $50 then it is In the Money (ITM). If the stock is ITM, the buyer of the put option will likely exercise the option. And the seller is obligated to purchase the underlying security at the agreed price.
- Strike price
This is the set price usually determined by the market valuation at which you exercise your put options. This is the price at which the seller of the put will buy the underlying commodity.
- Expiration
The expiration on a put contract is the last day or the final window where the buyer of the put option can exercise his rights to sell the underlying stock. Typically, the expiration is at 4pm on the third Friday of each month.
- Assignment
If the option buyer decides to exercise the rights to the contract, then the assets is transferred to the seller of the put option. If the buyer chooses not to exercise the option, he will retain ownership of the stocks and the contract expires worthless.
How a put option calls works
If a stock ERY is trading at $100 per share, and;
An investor, Jack believes that the stock will take a dip in the future (assume 60 days)
Or
Jack wants to purchase the stock, but at a lower price than the current market price ($90).
Jack can decide to write/sell a put option at $90 per share which will expire in 2 months. For the put option sale, he earns a premium of $1 per share which is paid to him.
However, Jack must possess the required funds to purchase the stock, which will be maintained in his brokerage.
- If by the end of the 2 months, the stock does well and is trading at $105, Jack has earned $1 per share in premiums, and the PUT contract expires (it will be a no brainer for the stockholder to not exercise his options right).
- However, if by the end of the 2 months, the stock does poorly as Jack predicted, and is trading at $80. The buyer of the put will likely exercise his PUT option, and Jack is obligated to buy ERY at the agreed $90 per share (even though the market price is $80). And either way, Jack keeps the $1 per share; premium and Jack begins to earn any dividend paid for owning the stock.
At the instance B, Jack has an OTM options contract since he loses $10 per share on the stock. Total profit = (Market price ($80) – Strike price ($90)) + Premium earned ($1) = -$9. However, if he had purchased the stock at the higher price of $100, he would have lost $20 a share.
For every, cash-secured put contract, there are generally three choices the trader can make.
- Allow the contract to expire.
From our example above, imagine example A occurs over the next 2 months, and the stock does well; the buyer of the option has no reason to sell his stocks. So, the buyer runs down the contract and keeps the stock and the option seller keeps the premium and looks at initiating another Cash Secured put.
- Assign the asset
This is when the option buyer decides, like in example B to exercise their put option. He transfers the asset to the writer of the options. Since the stock price has decreased, the option buyer will most likely exercise his option. The shares will be purchased using the existing brokerage cash. Please Note, I only sell put options on stocks that I am fine with owning. So, this is not necessarily a bad thing. Once you own the stock you can trade Covered Calls on the newly purchased shares.
- Buy-back the put option/close early
The Seller might want to take profits in the option before the expiration. This is to limit the assignment risk and to clear the trade so that the trader can issue another option. For instance, if you earn $200 in premium and the value of the contract has decreased to $15 then you can buy the option back and earn a profit of $185. At this time, you can sell another Cash Secured Put option.
Wrapping Up
The Cash Secured put option is a good income making option and allows you to earn premiums on any cash in your brokerage. In addition, you can purchase stocks that are below the current market price for possibly better long-term returns. Combined with Covered Call options (Discussed here) you can earn a nice income from the investments and cash in your portfolio.