What does cash secured put mean in option trading?

A cash secured put is an options strategy where an investor sells a put option and simultaneously sets aside enough cash to buy the underlying shares if the option is assigned, aim

A cash secured put is a conservative options strategy commonly employed by investors who are bullish or neutral on a stock and are willing to own it at a specific price. When you sell a cash secured put, you are essentially agreeing to buy 100 shares of the underlying stock at a predetermined strike price, should the stock price fall below that strike price by the option's expiration. In return for taking on this obligation, you receive an upfront payment from the option buyer, known as the premium. This premium is yours to keep regardless of whether the option is ultimately exercised.

The 'cash secured' aspect refers to the requirement that you must have enough cash in your brokerage account to cover the cost of purchasing 100 shares at the strike price. For example, if you sell a put with a strike price of $50, you need to have $5,000 (100 shares x $50) readily available. This safeguards against potential losses if the stock drops significantly and you are forced to buy the shares. The strategy has two potential outcomes: either the stock stays above the strike price, and the put expires worthless, allowing you to keep the full premium, or the stock falls below the strike price, and you are 'assigned', meaning you must buy the shares at the strike price. Investors often use this strategy when they are interested in acquiring a stock but want to do so at a price lower than its current market value, while also earning some income in the interim. It's a method of getting paid to wait to potentially buy a stock you already like.

Why it matters

Common mistakes

- Insufficient Capital: A common mistake is not having enough cash actually secured to purchase the shares if the put is assigned. This can lead to margin calls or forced liquidation of other assets, so always ensure full cash coverage.
Selling Puts on Volatile Stocks: While high volatility can lead to higher premiums, it also dramatically increases the risk of assignment and having to purchase shares of a highly fluctuating asset. It's generally safer to use this strategy on stocks you wouldn't mind owning for the long term.
Ignoring Assignment Risk: Some investors focus solely on the premium income and neglect the possibility of being assigned the shares. Assuming that the put will always expire worthless can lead to an unexpected purchase of stock, which ties up capital and exposes one to market risk.
Setting Strike Price Too High: Choosing a strike price that is too close to the current market price or even above it increases the likelihood of assignment, potentially forcing you to buy the stock at a price higher than you truly value it. Select strike prices that reflect a comfortable entry point for ownership.

FAQs

What happens if the stock price is above the strike price at expiration?

If the stock price remains above the strike price at expiration, the put option will expire worthless. In this scenario, you keep the entire premium collected and have no further obligations.

What is the maximum profit for a cash secured put?

The maximum profit for a cash secured put is limited to the premium received when you initially sold the option. This is because the put option can only expire worthless or be assigned, and in either case, the premium is your gain.

When should an investor consider using a cash secured put?

An investor should consider using a cash secured put when they are moderately bullish or neutral on a stock, are willing to own the stock at a lower price, and want to generate income. It's a strategy often used by those who don't mind acquiring shares if the price drops.