Cash-Secured Puts

Definition

The term cash-secured put refers to the strategy of selling a put contract with the intent to purchase the security when it trades at a price that is lower than its current market price.  A cash-secured put involves both writing the option and depositing cash in a sweep account to purchase the underlying security.

Explanation

If an investor would like to purchase shares of a security at a price lower than its current market value, one of their options is to sell a cash-secured put.  An investor will do this if they believe a security will eventually increase in price, but would like to purchase the security at a price point that is lower than it's currently trading.  This strategy is known as a cash-secured put because in addition to selling the put, the investor also deposits into his account enough cash to purchase the underlying shares of the security.

When writing the put, the investor receives a premium in exchange for the obligation to purchase the stock at the contract's strike price if assigned.  With a cash-secured put, the investor believes the price of the security will decline in the near term and increase in value over time.  Of course, there are two possible outcomes:

  • Assignment:  The price of the security declines below the strike price of the put, and the investor purchases the securities at the strike price using the cash in their account.  The investor also receives a premium for writing the put, which effectively lowers their net cost, or breakeven point, of the securities.
  • No Assignment:  The price of the security remains above the strike price of the put, and the investor does not purchase the securities.  When this occurs, the investor effectively loses the opportunity cost of owning the stock; however, they keep the premium paid for selling the put.

Example

An investor would like to own 100 shares of Company ABC's common stock, which is currently priced at $96.00 per share. The investor feels the stock provides good value at $90.00 per share or lower.  The investor also thinks the market price of Company ABC's stock will decline to $90.00 in the next sixty days.  The investor decides to write one out-of-the money put for $3.00.  In this example, there are three possible outcomes:

Stock Price Remains Above $90.00 per Share

If the strike price of the security remains above $90.00 per share, the investor does not purchase the shares at expiration; however, they get to keep $3.00 per share, or a $300, premium for writing the put.
Stock Price Drops Below $90.00 per Share H4

If this occurs, the investor is forced to purchase the shares at expiration and is exposed to an unrealized loss if the current market price of Company ABC's stock is below the strike price of $90.00 less the $3.00 premium received for writing the put, translating into a net cost for the stock of $87.00.  Once again, the investor believes the price of Company ABC will increase over time and wants to hold the securities in their portfolio, so they are not concerned about the unrealized loss.

Stock Price is Exactly $90.00 per Share

Although this scenario is unlikely, Company ABC's stock price could be $90.00 per share at expiration of the contract.  There is a chance the investor may be assigned since the put contract is considered at-the-money.  If assigned, the investor will use the cash in their account to purchase the shares, if not assigned, the investor still gets to keep the $300 premium for writing the put.

Related Terms

covered combinations, protective puts, index puts, Buy-Write Index