Who Should Consider Selling
Cash-Secured Puts?
- An investor who would like to acquire shares in a particular
security, but is willing to wait for them to trade at a target
price that is below current market level
Have you ever entered a limit order to buy a
security at a price below its current trading level? If so, you've
most likely experienced a waiting game, and possibly a lengthy one
because the stock will not be purchased until it trades at or below
your limit price. Instead of simply waiting for that to happen you
could take an approach that is a little more pro-active and sell
(write) a cash-secured put. You will be paid, in the form of the
premium received for selling the put, in return for accepting the
obligation to buy underlying shares if assigned, and at a price
lower price that you select in advance. Many large portfolio
managers as well as individual investors find this an attractive
means to acquire stock for their portfolios.
Definition
An investor who employs a cash-secured put writes a
put contract, and at the same time deposits in his brokerage account
the full cash amount for a possible purchase of underlying shares.
The purpose of depositing this cash is to ensure that it's available
should the investor be assigned on the short put position and be
obligated to purchase shares at the put's strike price. While the
cash is on deposit it may generally be invested in short-term,
interest-bearing instruments.
The net price paid for underlying shares on assignment is equal to
the put's strike price minus the premium received for selling the
put in the first place. For this reason, the strike price chosen,
less the premium amount, should reflect the investor's target price
for acquiring underlying shares. Regardless of the direction the
stock price takes after the put is sold, or whether assignment is
received or not, the put seller keeps the premium.
On the downside, the break-even point for this strategy is an
underlying stock price equal to the put's strike price less the
premium received for selling it. If the stock declines significantly
below the strike price by expiration, on assignment the investor may
be obligated to purchase shares well above their current price
level. Stock bought under this circumstance may therefore reflect a
loss compared to its market price at the time. However, this loss
would be unrealized as long as the investor holds the shares and is
positioned to profit from an increase in their price. Any investor
whose motivation in writing a cash-secured put is to buy underlying
stock should therefore be committed in advance to a target price for
a possible purchase, and select a strike price accordingly.
On the upside the risk is one of opportunity loss. After selling the
put the underlying stock price can go up and remain above the put's
strike price. In this case, neither a put seller who is not
assigned, nor an investor who originally entered a low limit order
for the stock instead, will buy the stock. The put seller, however,
keeps the put sale premium received.
How to Use the Cash-Secured Put to Buy
Stock at a Lower Price
Please note: Commission, dividends,
margins, taxes and other transaction charges have not been included in
the following examples. However, these costs can have a significant
effect on expected returns and should be considered. Because of the
importance of tax considerations to all options transactions, the
investor considering options should consult with his/her tax advisor as
to how taxes affect the outcome of contemplated options transactions.
Example
After thorough research an investor decides he'd like to
invest in ZYX stock. It's currently priced at around $48 per share, but
he feels it would be a good buy at around $45 (or lower) and that the
stock could reach that level within the next two months. The investor
can always place a limit order with his broker to buy ZYX shares at $45,
but he decides to write a ZYX put in order to acquire the same shares if
he's assigned. In the marketplace there are two 2-month ZYX puts
available that might suit his purpose: an out-of-the-money ZYX 45 put
trading for a quoted price of $1.50, and an in-the-money ZYX 50 put
trading for $4.00. Selling either of these puts would result in a
purchase of ZYX stock below the current market price of $48 per share if
assignment is made, but at different net prices. The investor should
sell one put contract for every 100 shares of stock he's willing to
purchase.
Remember, by selling the put with a $45 strike the
investor takes on the obligation to buy 100 ZYX at $45 per share should
he be assigned at any time before the option contract expires, and at a
net purchase price of the $45 strike less the put premium received. By
selling the $50 put the investor would be obligated, if assigned, to buy
100 ZYX shares at a net price of the $50 strike less the put premium. In
either case, the obligation is there to buy stock at these prices no
matter how low ZYX might decline in price by expiration.
With ZYX stock currently trading for $48 per share,
consider the consequences of the investor's choice between placing a
limit order to buy 100 ZYX shares outright at $45 per share with selling
one of two put contracts:
- Out-of-the-money ZYX 45 put at $1.50
- In-the-money ZYX 50 put at $4.00
Placing a Limit Order to Buy 100 ZYX at
$45
vs.
Selling 1 ZYX 45 Put at $1.50
In this case the investor is committed in advance to a
purchase of 100 ZYX shares at $45, below the current level of $48, so he
sells the out-of-the-money ZYX 45 put for $1.50 and deposits the
purchase price of $4,500 ($45 strike x 100 shares) into his brokerage
account in case he's assigned. Consider three possible option expiration
scenarios, and compare the outcome of each to the placement of a limit
order to buy:
- The stock remains above the $45 strike after the put sale, in
which case the investor would not be assigned and not buy 100 ZYX
shares
- The stock is below $45 by expiration, in which case the investor
can expect to be assigned and obligated to buy the stock at $45
- The stock closes exactly at $45 at expiration
ZYX remains above $45 between put sale
and expiration - investor not assigned
Whether by selling a cash-secured $45 put,
or by entering a limit order to purchase the stock at $45 per share, the
investor will not buy shares and participate in a rise in the price of
the ZYX. However, if the investor had sold the $45 put, after expiration
he would keep the $150 net premium received. At that point he could
either sell another put, or possibly buy the 100 shares outright, at a
current price less the $150, if he feels it's a good investment.
ZYX is below $45 at expiration – investor is assigned
Using a limit order to buy ZYX at $45 the investor would
see an unrealized loss equal to the amount ZYX stock was below $45 at
expiration. By selling the $45 put for $1.50 the investor's net purchase
price for the 100 shares is actually lower than his target price of $45:
$45 strike - $1.50 premium received = net share price of $43.50. Only
below this price, the break-even point for the strategy, would the
investor begin to see an unrealized loss on his stock purchase. Should
ZYX decline significantly by expiration the investor still has the
obligation to buy the stock at $45, whether by limit order or put sale.
ZYX is exactly at $45 at expiration
The investor may be in either situation described above. With a limit
order to buy at $45 he may or may not have bought the stock, depending
on whether it traded at or below $45 before expiration. If the put was
sold instead, the investor may or may not be assigned on this expiring
at-the-money put contract, and may not be notified by his brokerage firm
until the next business day after expiration. Assigned or not, he
retains the put premium received.
Placing a Limit Order to Buy 100 ZYX at
$46
vs.
Selling 1 ZYX 50 Put at $4.00
Selling an out-of-the-money put is one way
to purchase underlying shares below current trading levels, but an
investor might also consider selling an in-the-money put. Depending on
the amount of premium received, this approach may also provide a
purchase price that fits an investor's target price. One benefit of this
approach is that the investor's chance of being assigned and purchasing
stock is greater than from selling an out-of-the-money put. This is
because the put is already in-the-money, so the underlying stock price
does not need to drop for possible assignment at expiration. Another
benefit is that the investor keeps a larger premium amount for selling
an in-the-money put in case the stock price increases above the strike
price and the option expires out-of-the-money and worthless.
Once again we will assume ZYX is currently trading at $48, and that an
investor would like to own ZYX, but not at this level. He thinks that
ZYX would be a good buy at a lower price, and is committed to a purchase
around $46, so he sells an in-the-money ZYX 50 put for $4.00. If
assigned at any time before expiration, the investor's net purchase
price fits his target price: $50 strike price – $4.00 premium received =
$46 per share. After the put's sale, the investor deposits into his
brokerage account the full stock purchase price of $5,000 ($50 strike x
100 shares) in the event he is assigned.
Comparing each to the placement of a limit order to buy, consider four
possible option expiration scenarios:
- the stock remains above the $50 strike after the put sale, in
which case the investor would not be assigned and not buy 100 ZYX
shares
- the stock is below $50 by expiration, but above the limit price
of $46, in which case the investor can expect to be assigned and be
obligated to buy the stock at $50
- the stock is below $46 by expiration in which case the investor
can expect to be assigned and be obligated to buy the stock at $50
- the stock closes exactly at $50 at expiration
ZYX remains above $50 between put sale
and expiration - investor not assigned
Whether by selling a cash-secured $50 put
or by entering a limit order to purchase the stock at $46 per share, the
investor will not buy shares and participate in a rise in the price of
the ZYX stock. However, if the investor had sold the $50 put, after
expiration he would retain the $400 net premium received. At that point
he could either sell another put, or possibly buy the 100 shares
outright, at a current price less the $400, if he feels it a good
investment.
ZYX drops below 50, but remains above 46 by expiration - investor
assigned.
Selling the $50 cash-secured put for $4.00
allowed the investor to buy ZYX at his net target cost of $46, even
though ZYX never traded there. He has no unrealized loss on the stock
purchase since $46 ($50 strike - $4.00 premium received) is his
break-even point. Had he used a limit order to buy ZYX at $46, he would
not have purchased any stock.
ZYX drops below 46 by expiration - investor assigned
Whether by selling a cash-secured $50 put
and being assigned, or by entering a limit order to purchase the stock
at $46 per share, the investor will buy 100 ZYX shares. In either case,
however, the investor would have an unrealized loss on the stock
purchase by the amount ZYX is below $46 at expiration.
ZYX remains above $46 after put purchase but is exactly at $50 at
expiration
With a limit order to buy at $46 the investor will not buy 100 ZYX
shares; by selling the $50 put he may or may not be assigned and buy the
stock. If no assignment is received beforehand, the investor may or may
not be assigned on this at-the-money put contract at expiration, and may
not know which is the case until he's been notified by his brokerage
firm on the next business day. Assigned or not, he retains the put
premium received.
Summary
Selling a cash-secured put is a strategy that
allows an investor to be paid a premium for the obligation to buy a
particular stock at the put's strike price if he's assigned. This
strategy provides him the opportunity to purchase an underlying security
for a price that is lower than it is currently trading. The premium
received for selling the put can give him some downside price protection
by lowering his break-even point on the stock purchase, while placing no
limit on how high the stock can be subsequently sold. On the upside, the
investor's risk is one of opportunity loss if the stock increases, he's
not assigned and shares are not purchased. But assigned or not, he keeps
the put premium received.
By selling an out-of-the-money put an investor can select a target price
for possible stock purchase if the stock price drops and assignment is
received. On the other hand, by selling an in-the-money put he might be
able to purchase underlying shares at a target price below current price
levels, but without a drop in underlying stock price.
Note: Assignment prior to expiration
Many option professionals will exercise deep in-the-money puts before
expiration when their current market premiums have little or no time
value remaining. For this reason, investors with short positions in such
puts might receive early assignment.
