What is a Cash Secured Put?

A cash-secured put is an options trading strategy whereby the investor/trader sells a put option contract while simultaneously setting aside enough cash to cover the potential purchase of the underlying asset. This strategy is considered conservative because it involves setting aside a cash reserve to cover the potential purchase of the underlying asset. In that regard, the cash reserve acts as a safety net for leverage, as the trader is required to put up the same amount of capital as the entire risk of 100 shares of stock at the strike price.

If the price of the underlying asset remains above the strike price at expiration, the put option expires worthless, and the trader keeps the premium as profit. However, if the price falls below the strike price, the put buyer may elect to exercise the option, requiring the put seller to buy the asset at the strike price. In this scenario, the put seller uses the cash reserve to purchase the asset, effectively reducing their cost basis by the amount of premium received.

Overall, the cash-secured put strategy is favored by investors and traders that seek income generation, and are also somewhat bullish on the underlying stock or ETF. That’s because in the worst-case scenario, 100 shares of the underlying stock/ETF would be “put” to the option seller at the strike price and they would assume the risk of the shares going forward, less the credit

A cash-secured put is an options trading strategy where an investor sells a put option contract that requires enough cash to cover the potential purchase of the underlying asset if the option is exercised. The overall dynamics of the cash secured put strategy are outlined below. 

Basic Overview of Cash Secured Put

• Selling Put Option: The trader sells a put option, agreeing to buy the underlying asset from the option buyer at a predetermined price (strike price) if the buyer decides to exercise the option.

• Cash Reserve: To fulfill this obligation, the trader sets aside enough cash in their account equal to the strike price multiplied by 100 shares per contract. This cash basically serves as collateral.

• Premium Receipt: In exchange for taking on this obligation, the trader receives an extrinsic value premium from the sale of the put option(s). 

Basic Example of a Cash Secured Put

Imagine a trader sells a cash-secured put on hypothetical stock XYZ which is currently trading $55/share. The trader sells the $50-strike put for $2.00. 

Best-case Outcome: At expiration, the price of Stock XYZ remains above $50. The put option expires worthless, and the trader keeps the premium received from the sale of the option. The trader therefore earns income from the sale of the put. 

Suboptimal Outcome: Imagine the underlying price of stock XYZ falls to $45 at expiration. In this scenario, the put seller would be obligated to purchase 100 shares of stock XYZ at $50 each, using the associated cash reserve. If the option price was $2, the effective purchase price of 100 shares of the underlying stock is $48 per share or $4800. 

The maximum profit and loss for a cash-secured put strategy can be calculated using the formulas outlined below. 

Maximum Profit

• Maximum Profit: The maximum profit is equal to the premium received from the sale of the put(s). 

• The maximum profit is achieved when the underlying asset remains above the strike price at expiration, causing the put option to expire worthless. In this scenario, the trader keeps the entire premium received as their profit.

Maximum Loss

• Maximum Loss: The maximum loss is calculated using this formula, (Strike Price - Premium Received) x Number of Contracts x 100 shares.

• The maximum loss is realized if the price of the underlying asset falls to $0.00. The trader is obligated to buy the underlying asset at the strike price, and the premium received provides partial downside protection below the strike price. 

There are several ways to close a cash-secured put position or exit the trade. These choices are outlined below. 

Buy to Close

• The most common method to exit a cash-secured put position is to buy back the put option that was initially sold.

• By buying back the option, the trader effectively cancels their obligation to buy the underlying asset at the strike price.

• This can be done at any time before expiration, and the price at which the option is bought back will determine the profit or loss of the trade.

Allow the Option to Expire

• If the price of the underlying asset remains above the strike price at expiration, the put option will expire worthless.

• In this case, the trader does not need to take any action, and the cash used to secure the put position is released back into his/her account.

• However, it's essential to monitor the position closely to ensure no unforeseen events occur before expiration.

Rolling the Position

• Rolling involves closing out the current cash-secured put position and simultaneously opening a new short put position with a later expiration date and/or different strike price.

• This strategy allows the trader to extend the duration of the trade, and to potentially adjust the strike price to better align with their outlook on the underlying asset.

• Rolling can be used to capture additional premium income or to manage a position that may be moving against the trader's expectations.

Assignment

• Assignment occurs when the trader who sold the put option is obligated to buy the underlying asset at the strike price.

• This happens when the option buyer exercises the put option, or if the strike price is above the market price and held through expiration.

• The trader must be prepared for assignment if the short option is in-the-money at expiration.

Depending on one’s outlook and risk profile, the cash secured put strategy may be an attractive approach. But this strategy offers specific advantages or disadvantages, as outlined below.

Pros

• Income Generation: Selling put options generates upfront extrinsic value premium income for the trader for taking risk in the stock or ETF.

• Lowering Cost Basis: If the option is exercised, the trader is obligated to buy the underlying asset at the strike price. This can be advantageous if the trader wants to acquire the asset at a predetermined price, potentially at a discount to the current market price.

• Flexibility: Traders can choose strike prices and expiration dates that align with their market outlook and risk tolerance. Additionally, the position can be closed or adjusted before expiration. 

Cons

• Limited Profit Potential: While the premium received provides income, the maximum profit is limited to the premium received upfront. This caps the potential upside compared to other strategies with unlimited profit potential.

• Obligation to Buy: By selling a put option, the trader is obligated to buy the underlying asset at the strike price if the option is exercised. This obligation ties up capital and may lead to asset acquisition in unfavorable market conditions.

• Market Risk: The strategy exposes the trader to the risk of adverse price movements in the underlying asset. If the price declines significantly, the trader may incur losses, even if they are able to buy the asset at the strike price.

• Opportunity Cost: Setting aside cash to secure the put position limits the trader's ability to deploy those funds elsewhere. This represents an opportunity cost, particularly in rising markets where alternative investment opportunities may offer higher returns.

• Potential for Assignment: If the put option is exercised, the trader may be assigned to buy the underlying asset at the strike price. While this can be advantageous in some cases, it may also result in untimely asset acquisition. 

A cash-secured put is a straightforward options trading strategy where the investor sells a put option contract while simultaneously setting aside enough cash to cover the potential purchase of the underlying asset at the strike price. This strategy is conservative, as the cash reserve acts as collateral, providing a clear understanding of the maximum potential loss, aiding in effective risk management. The strategy also generates income through the upfront premium received, offering a buffer against potential losses below the strike price.

On the plus side, selling put options generates upfront premium income for the trader, providing a source of income. Moreover, the cash secured put offers flexibility, allowing for customization according to individual risk tolerances and market outlooks. This is due to the wide variety of available strike prices and expiration dates.

On the other hand, the cash secured put does have some limitations. The profit potential is capped at the premium received, meaning an investor/trader could miss out on significant gains if the underlying asset's price rises substantially. Additionally, the cash reserve, while providing downside protection, ties up funds that could be used for other investments, leading to potential opportunity costs. Moreover, if the short put is assigned, this may force the investor/trader to acquire the underlying asset at an untimely moment. 

Despite these limitations, the cash-secured put strategy remains popular among investors and traders that seek conservative income-generation. Depending on one’s outlook and risk profile, this strategy may offer a balanced approach between risk and reward when implemented effectively.