We recently took a look at the covered call strategy and how it can be used to not only generate monthly income but also sell out of stock positions if your shares get called away. If your shares get called away there is still a way to collect your monthly options premiums and get back into a stock at a price which you desire. One simple way to accomplish this is to use cash secured puts. Using cash secured puts is appropriate for both novice and sophisticated investors, and I have used them numerous times to not only generate monthly income but also get into a stock at a price I find favorable.
The cash secured put is opposite of the covered call in many ways. With this strategy you are still writing options with an expiration date and a strike price. However, with puts, if the share price of the stock falls below the strike price on expiration, the stock will be “put” to you and you will be forced to purchase the shares at the strike price. When you write cash secured puts, you collect the premium from the put option and you get to pocket it no matter what. The put must be “cash secured” because if the share price falls below the strike price then you will be forced to buy it on expiration or if the put buyer exercises the option. In this scenario you will need the cash to make the purchase. Like call options, one put option controls 100 underlying shares of the stock. Let’s take a look at an example.
I will use real quotes with a historical example. It is September 24th, 2012, and an investor wants to buy 1000 shares of Bank of America (BAC) at a price of $8.00; however, the current share price is sitting around $9.22. The investor would like to make some return on the cash sitting around in his account but does not want to purchase any stocks at the current market valuations. He decides to sell 10 cash secured puts for BAC with an $8.00 strike price that expire on December 22. Looking at a recent quote for the Dec 22 expirations, he could sell each option for $24.00 for a total of $240. That money is the investor’s money to keep no matter what the outcome. It can be withdrawn for personal use or reinvested for more gains. The investor has now earned money in the form of cash secured put premiums just for waiting for a decline in the stock price. He is getting paid to wait and purchase shares at a price that he wants! When December 22 rolls around a few scenarios could take place…
If on December 22 the price of BAC is above $8.00, then the puts expire worthless, and the investor does not have to purchase any stock. In fact, the investor can now turn around and write 10 more cash secured puts and earn more premiums! This kind of strategy can work great in a sideways market because every expiration date the investor has the opportunity to write more cash secured puts. The premiums from doing this over a year can really add up. In fact, if the investor were able to write 10 cash secured puts every 3 months for $240, then he would have $960. Of course, he had to set aside $8,000 to secure the puts, and this equates to a 12% return on his money without ever actually owning the stock.
If on December 22 the price of BAC has fallen below $8.00, then the stock gets put to the investor, and he is forced to buy 1000 shares of BAC at $8.00. This is precisely what the investor wanted, so this is great news for him. Now he can start collecting dividends from BAC. Although a paltry dividend at the time, BAC did pay one. If the investor still desires a monthly income from option premiums, then he can now turn around and sell 10 covered calls against his shares in BAC. If not, then he doesn’t have to, and he can hold the position for the long term for tax advantages and more capital gains. The investor has purchased the shares at a price that he originally wanted to purchase them at in this scenario. He was essentially paid a premium to buy shares when he would have bought them anyways.
As you can see, writing cash secured puts is a great way to generate monthly premiums while waiting for the right price to enter a stock position. If you feel the stock market is at a near term top, then consider writing cash secured puts in order to get a better entry point. Like call options, put options are affected by the same factors such as how distant the share price is from the strike price, time until expiration, and volatility. If stock market volatility rapidly increases on a down day, then you may want to take advantage of the inflated option premiums and write a few cash secured puts. Investors will be willing to pay more to buy puts when volatility is increased! Some of the disadvantages of this strategy are that all option premiums are taxed at as a short term capital gain. Another is that you may be forced to buy a stock at $8.00 when it has declined to $7.50. That is why you must be very confident of the price you want to enter the position at.
This article covers the very basics of writing cash secured puts. It is a nice strategy for those who want to wait for price declines, and the premiums can add up very quickly in a sideways market. Because you are getting paid to buy a stock at a price you would have bought it at anyways, many investors will say you are getting paid to buy the stock. Another common expression from die-hard option users is never buy a stock for free. Of course there is a time and place for every strategy, and this one may not always be appropriate. Definitely give this strategy a look if you want monthly income and better entry points in some stock positions.