The world of options trading provides many avenues for making money. We can capture gains on a directional stock move, protect our holdings from a retracement, capitalize on a sideways channeling stock, even generate income from various trade strategies. Let’s discuss a strategy that can be employed as an income generator or a directional trade…Cash covered puts.
Cash covered puts is a strategy in which we sell put options to open our position, in hopes that the stock will either stay where it’s at or go higher. This strategy is very similar to selling covered calls, in that we are selling options in the hopes that they will expire worthless. When the option we sold expires worthless, we get to keep the entire premium received.
The premium we receive when selling the put option is the maximum we can gain in this strategy. The risk of the trade comes when the stock moves against us (down) and we are assigned on the put. When a short put is assigned, we are obligated to purchase the stock at the strike price. When we enter our position, the ‘cash covered’ portion is referring to our setting aside the amount of cash that would be required to purchase the stock upon assignment.
Now, let’s break this down a bit more. The main risk in this strategy is not necessarily that we can be assigned. Rather, the risk is what could happen after the assignment, once we hold the stock. By being assigned, this means that the stock has dropped below our strike price. Therefore, we will be buying the shares at a price higher than the current market. If the stock continues its downward move, we are subject to a loss on the shares.
Generally, entering a cash covered put trade means that we are willing to buy the stock at the strike price sold. So, in theory, even if we are assigned the shares, we are prepared to take the stock at the strike price, in anticipation of a bullish move from there.
It is important to note the difference between selling puts that are cash covered and selling naked puts. Selling naked means that we have not set aside the cash to purchase the stock if assigned. If the stock goes against us in this scenario, we are obligated to buy shares of something we may not want to own, and we may not even have the cash available to purchase the stock. We must remember that our broker is going to be protecting himself. If we are forced to buy something we don’t have cash for, he will liquidate the stock for us…potentially locking in a substantial loss. The risks of selling naked are vast. One should never pursue such a strategy unless they are very clear about and comfortable with the risks involved.
So, back to cash covered puts…below is an outline of this strategy in action. As we walk thru this example, remember that this is just for education and informational purposes. No recommendation should be implied. Commissions are excluded for this example.
Agrium (AGU) closed on 4/15/09 at $41.28. This trade illustrates an out-of-the-money put. 4/15/09 sold puts to open 10 contracts of AGU May 40 puts @ $2.40. Proceeds = $2400. 4/15/09 set aside cash to cover purchase of 1000 shares of AGU at 40, less proceeds from put sale. Cash held = $37,600.
If we fast forward to expiration day in May, we find that AGU has advanced to $48.18 per share. Therefore, our May 40 puts will expire worthless…and we will keep the $2400 as profit.
The breakeven for our position was $37.60 per share (40 strike – $2.40 credit). This means that even if the stock had dropped below the strike of 40, we would still be profitable in the trade as long as the stock were above 37.60. As you can see, this allows us to profit if the stock continues moving higher, and also allows us to buy into the stock at a lower price if we are in fact assigned. The stock was actually trading around $38 for several days after we got into our position. Imagine if we were assigned at that point. We would have purchased the shares at $40, but our cost basis for the stock would be $37.60 (40 strike – $2.40 credit). When the stock moved to $48.18, we would have a gain of $10.58 per share ($48.18 – $37.60), or $10,580 net profit.
So in the above example…either having the puts expire worthless, or being assigned and riding the stock rally would have provided a nice return. Selling cash covered puts is a neutral to bullish strategy. Remember that you need to be willing to purchase the stock in order to make this a reasonable trade.
Another approach to selling cash covered puts might be to sell the options in-the-money at the start of our trade. This would cause the likelihood of assignment to be much higher. If this is our approach, we are using the short put as a method to enter a stock position. This will allow us to get into the stock with a lower cost basis due to the premium we receive from selling the option. This would be a much more directional trade. If we were confident that the stock was likely to rally in the next few weeks, this could be a method of trading it.
We have not addressed things like volatility and time much in this discussion. That should in no way imply that these factors are unimportant. On the contrary! The basis of selling options in any strategy is to capture time decay. Selling cash covered puts is no different. We will generally be looking at somewhere around 30 days till expiration for our options. We want to enjoy the rapid decay of time premium in those last few weeks of an option’s life.
Volatility is another crucial factor in any trade. Generally when selling options, we will look for inflated implied volatility premiums. This makes the option prices more appealing to sell. High implied volatility can be dangerous too, though. When IV is high, it implies that the stock is going to be moving more in the coming days/weeks. If we are incorrect on our directional choice, this can hurt us. Selling cash covered puts will help us cushion the blow when the stock moves against us (down), but only to a small degree. We are protected to the down side by the premium we bring in and the distance we are out-of-the-money.
This article is meant to be a brief introduction to the strategy of selling cash covered puts. We have not addressed things like entry/exit or risk management in any detail. These are critical factors in every trade we place. I strongly encourage you to consider the details of your risk management rules, entry and exit criteria as they relate to this strategy before ever putting money at risk. Happy trading!
You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
