By Ee Hsin Kok. Edited by Arjun Chandrasekar.
Overview
Have you ever wanted to own stock but it was too overpriced for you to buy it? You wait weeks or even months, and the price fails to drop to your buy point. It can be quite a frustrating experience for most people. But there’s actually a way to make the process less frustrating, a way to get paid while waiting for the price to drop. This can be done by selling cash-secured puts.
What is a Cash Secured Put?
When you sell a put at a certain strike price, it means that if the option expires in the money, you are obligated to buy 100 shares per option contract at that strike price. So for example, the price of Apple is at $154 today, and you sell 1 put with an expiry date 32 days from now at $140, collecting 0.80 per share as a premium ($80 total). In 32 days, Apple will either stay above $140, or it will close below it.
If Apple stays above $140, whether it closed at $141, $154, or $160 doesn’t matter. You will keep your $80 premium.
On the other hand, if Apple closes below the strike price of $140, it is considered in-the-money, and hence you are obligated to buy 100 shares of Apple at $140. Since you collected a premium of 0.80 per share, your net purchase price would actually be $139.2.
Should you sell Cash Secured Puts?
The two most important things when selling cash-secured puts is that you have a desire to own the company and that you have the cash to buy 100 shares per option contract you sell. This is because once you sell a put, you are obligated to buy at the given strike price. Regardless of how much the stock may fall below that strike price, you have to buy at the strike price.
Using the example above of Apple, if Apple fell to $130, you would still have to buy it at $140. Even after factoring in the 0.80 premium, that would mean a loss of $9.2 per share, or $920 per option contract sold. This would not be a problem if you wanted to own Apple shares because if you did not sell the put, you would have bought Apple at $140 anyway and would be facing the same loss. Additionally, since you believed in the company and wanted to own it, you would have had the conviction to hold the shares as you waited for a rebound. On the other hand, if you sold cash-secured puts on a weak company that you did not believe in, and the market price dropped way below your put’s strike price, you would not want to keep holding the lousy company and would be forced into realizing your loss.
The Optimal Scenario to sell Cash Secured Puts
The best time to sell cash-secured puts would be when you are eyeing a great company that you want to own, the company’s shares are on an uptrend or are a little overvalued, and you want to wait for a retracement to buy it. Instead of waiting for a retracement to your buy points (which might take months or years), you could sell cash secured puts at those buy points. This means you get to collect premiums while waiting for the price to drop. If the price never drops, you would have collected good premiums for your patience (usually about 1-2% per month), and if it does drop, you would be able to buy the shares at the great price you wanted to buy them at anyway (and you get to keep the premiums too!).
Conclusion
Selling cash-secured puts is a great way for investors to be paid while waiting for their favorite companies to retrace. Under the right circumstances, it can create win-win scenarios for investors, where they benefit regardless of if prices drop or rise. Mastering it can mean boosting your portfolio’s returns tremendously over the long run.
