Trading cash-secured puts is a great way to learn how options work
A cash-secured put is an income options strategy that involves writing a put option on a stock or ETF and simultaneously putting aside the capital to buy the stock if you are assigned. In simpler terms, it is when you write a contract where you promise to purchase 100 shares of stock in exchange for being paid a premium. This strategy can be used to generate income while simply obligating yourself to purchase a stock that you would already like to own anyway.
Example of a Cash-Secured Put (CSP)
The concept of this strategy can seem confusing at first, but once you see a real example it becomes a lot easier to understand. Let’s make a theoretical scenario using the stock AAPL.
- Let’s assume that AAPL is trading at $100 per share
- You can sell an $80 strike CSP that expires in 30 days and receive $100 ($1 per share) in premium.
- You will be forced to set aside $8,000 in case you have to purchase the shares
- Two things can happen with this trade:
- AAPL stays above $80 at the end of 30 days, and you simply keep your $100 as income
- AAPL is below $80 on expiration, and you are forced to buy 100 shares of AAPL at $80 per share and you get to keep the $100
Worst Case Scenario When Selling Cash-Secured Puts
When learning about option strategies you must always be aware of the largest loss you can incur or simply the worst-case scenario. If you educate yourself about the risks of cash-secured puts you should have no problem with even the worst outcome which is getting assigned 100 shares of stock at the strike price.
Option selling strategies can often get a bad rap because without the proper knowledge of notional value, you can easily over-allocate your account and face large losses. However, if you are simply selling cash-secured puts you are not using any margin at all! The only problem with over-allocation that comes about when selling options is when you do not have the capital to cover the cost of assignment. Some brokers allow you to only put up just 20% of the required capital to cover assignment initially when selling put options which can give people a false sense of security of what they are risking.
Once you become a more seasoned trader, a little bit of margin usage is fine if you know how to manage your risk effectively. As a beginner, it can be a great idea to stick with cash-secured strategies so that you have no way of getting a dreaded margin call in the worst-case scenario where stocks crash hard.
Cash-Secured Put Trading Tips
Only trade liquid stocks
- Make sure the bid-ask spread is no larger than 10-20 cents wide
- The ETF ‘SPY’ has the most liquid options and generally has a tight penny-wide spread
Don’t sell cheap contracts
- If you sell a put and only collect $.05, eventually fees will negate profits
- Weekly options may expire sooner but since you are trading them more often you will incur more fees
Take profits early
- As opposed to letting options expire worthless, you can close them before expiration to lock in profit and collect more premium
- It is better to forfeit a small amount of premium instead of letting the option completely expire
Important Takeaways Before Trading Cash-Secured Puts
Writing cash-secured puts is one of the best ways to learn how options work without the risk of a margin call. You will be able to sleep well at night and be able to learn how options move based on what happens with the stock market. However, options were made to efficiently leverage your account without paying margin interest. Once you become comfortable trading cash-secured puts you can think about utilizing margin to increase your returns.