What is a cash-secured put?
A cash-secured put strategy involves selling a put option while holding enough cash to buy the underlying asset if the option is assigned. This obligates you to buy 100 shares of the underlying asset at the strike price if exercised.
The objective is to generate income from the premium received for selling the put option while being prepared to buy the underlying asset at the strike price if necessary.
Risk Reward:
- Risk: If the stock price falls significantly below the strike price, you will have to buy the stock at a higher price than its current market value, which can result in a loss.
- Reward: Limited to the premium received. The maximum gain is the premium if the stock price stays above the strike price.
Example:
You have $5,000 set aside to buy XYZ stock if needed. You sell the XYZ $50 put option expiring in 60 days for $3.50:
The theoretical max gain is $3.50 per share, or $350 total for the option sold, if XYZ stock price remains above $50 by expiration.
The theoretical max loss of XYZ is equal to the strike price of the contract minus the premium collected. This occurs if the stock price falls to $0 and the total loss would be $4,650 or $46.5 per share which is the total cost to purchase the stocks at the strike price of $50 minus the premium received of $3.50.
The breakeven point at expiration is $46.50. It’s calculated by subtracting the premium received ($3.50) from the strike price ($50).
How should I manage a cash-secured put position?
A cash-secured short put benefits if the underlying stock price stays above the strike price. As time passes, the option's extrinsic value decreases, which is beneficial for the seller. Additionally, if implied volatility drops, the option loses value, assuming other factors remain constant.
Although holding your cash secured put until expiration is an option, it's not the only way to close the position. There are multiple strategies for closing a covered call. You can either buy back the call to close your position, roll your position, or hold through expiration.
What should I do if my cash secured put is expiring soon?
About 30-45 days before expiration, time decay accelerates, causing the option to lose extrinsic value faster.
As the expiration date approaches, decide whether to buy back your short put, roll it, or hold it until expiration. If the option is profitable, consider taking action before expiration. Many traders choose to close or roll a short put during the expiration week to lock in profits and avoid the risk of assignment.
If the stock price rises or stays above the strike price:
- The put option will lose value, which is beneficial.
- To exit the position before expiration, you can buy to close the put option.
- If the option expires worthless, you keep the premium.
If the stock price drops below the strike price:
- The put option will gain value, which is a potential loss for you.
- To exit the position before expiration, you can buy to close the put option or roll it to a later expiration date.
- If the option is assigned, you must buy the shares at the strike price, which could be above the current market price.
What happens if my cash-secured put is assigned?
If assigned, you must buy the shares at the strike price. Ensure you have sufficient cash and are prepared for potential losses if the stock price is below the strike price.
How can I avoid my short put being assigned?
Closing your cash-covered short put position before expiration can help manage risks and lock in profits. By buying to close or rolling your position, you avoid the uncertainty of the expiration process and potential losses if the stock price moves unfavorably.
Early assignment happens when the buyer of the put option exercises it before expiration. As the seller, you must buy the shares at the strike price. This usually occurs when the stock price is significantly below the strike price, and the option has little to no extrinsic value left.