Cash Secured Puts- How It Works, Benefits and Limitations
Cash secured put is an option selling strategy with a primary motivation of buying a stock at a price below its current market price. In this strategy, an investor sells a put option of a stock while keeping aside the requisite cash to buy that stock at a predetermined price.
One main difference between cash secured put options and naked put options lies mainly in their motivation and aim. Cash secured put options is a stock acquisition strategy which doubles up as an income-generating strategy. In contrast, naked put options do not have a stock acquisition goal like cash secured puts.
Continue reading to know more about this stock acquisition strategy in detail.
How Do Cash Secured Puts Work?
Cash secured put is an investment strategy to acquire stocks at a lower price than their current price. Thus, a seller enters into a put contract with a buyer, intending to buy a stock at a specified price on that specified date. One implements this strategy on stocks with strong fundamentals and long-term value.
If that stock’s value falls to that specified limit then the seller will buy that stock at that particular price. An advantage here is that the premium that they received from the buyer further reduces the overall cost of purchased stocks.
In case that stock does not fall till that determined price, a buyer might refrain from honouring their contract. In this scenario, the seller does not incur any losses and in fact, gains the premium as a profit.
Thus, an investor gets to make a profitable way of buying a particular stock by using a cash secured put method. There are two primary risks of implementing a cash secured put strategy. Firstly, there is a loss of opportunity if the stock’s price does not go down. Secondly, there is a risk of the stock price continuing to plummet below its strike price.
Example of Cash Secured Put Strategy
We can understand this strategy better by resorting to an example.
Mr Kumar is a trader who wants to purchase 100 shares of Tata Consultancy Services Limited (TCS) at ₹2,000. However, the current price of TCS shares is valued at ₹2,500.
Here Mr Kumar can resort to two plans of action. One is to wait for stock prices to dip. Another is to deploy the cash secured put strategy. He decides to go for the second.
Thus, he sells a put option of TCS at a strike price of ₹2,000 for a premium of ₹20. The lot size of this TCS put is 100 shares.
The total premium that Mr Kumar will be receiving will be ₹20 x 100 = ₹2,000.
The contract value agreed upon stands at ₹2,000 x 100 = ₹2,00,000.
Since the contract value stands at ₹2,00,000, Mr Kumar will have to keep this amount in his trading account to buy those TCS shares. As sellers need to have sufficient cash to exercise the put option sold, this strategy is called a cash secured put.
Let us consider some situations and analyse the profits and losses of Mr Kumar.
- If on expiration date, TCS is trading at ₹1,900, Mr Kumar will incur a loss on his put option. In this case, he will have to buy TCS shares at a higher price than the current price. Thus, his losses will be: (₹2,000- ₹1,900 – ₹20) x 100 = ₹8,000. The losses are calculated as: (Strike price – Spot Price – Premium) * lot size.
- Now let us consider what will happen if, on the option’s expiration date, its spot price is ₹2,000. In such a case Mr Kumar will be in a profitable position as he will be able to buy that stock at the desired price as well as pocket the premium that was charged.
Thus, profits made through premiums lower buying price of the shares. Therefore, the actual price at which Mr Kumar now brought TCS shares is ₹1,980 when the spot price is ₹2,000.
- In another scenario, if the spot price is ₹2,100 on its expiration date, then also Mr Kumar will be in an advantageous position. As the spot price is more than the strike price in this situation, the put buyer will probably decide to not honour this contract.
In such a case, the put seller still gets the advantage and keeps the premium money as the profit. The profit in this scenario would be ₹20 x 100 = ₹2,000.
Benefits of Cash Secured Puts
There are several advantages of using the cash secured put strategy due to which it has become popular amongst many traders and investors. Some of the major advantages of this strategy are:
- Profits from the Premium
One of the biggest advantages of investing in this strategy is that selling a put will get you a premium. This means that even if the put option expires worthless, the investor can pocket the premium.
- Option for Earning From Low-Dividend Stocks
Cash secured puts if implemented properly, is an excellent way through which you can increase your cash flow from stocks which offer rapid growth but low dividends.
- Quick Reinvestment of Gains
Cash secured puts can give the needed immediate cash flow. It makes the option income more attractive.
Limitations of Cash Secured Puts
Despite its various advantages, cash secured puts also carry several disadvantages. Some major disadvantages of cash secured puts are:
- No Dividend Benefits
As you are yet to own the shares, you will not be earning dividends on them. The only payment that you will get is a premium which will be your cash flow until it expires.
- Complicated Process
Investors tend to prefer a simple buy-and-hold strategy over any complicated strategy. However, the cash secured put is a complicated and time-consuming strategy. The whole process of selling puts to buy stocks when the put buyer exercises their right to sell is a pretty long process.
Furthermore, as the put buyer does not have the obligation to sell, it is much a more time-consuming process.
- Tax Implication
The income from selling cash secured puts is treated as a type of business income and thus becomes taxable. Such income is liable for taxation based on the slab applicable to the investor. If the trader had rather owned the stock for over a year, they could have gotten the benefits of lower taxation on long-term capital gains.
Cash secured puts are an option selling strategy with the motivation of buying stocks at prices lower than the current price. This strategy is suitable for shares which you eventually want to own. Moreover, it provides you with additional income in the form of premiums. However, it has several cons too, which must be taken into consideration.
Frequently Asked Questions
What happens when stock prices are higher than the strike price of a put on the expiration date?
If the stock price is higher than the strike price of a put on the date of expiration, then the put expires worthless. But the seller keeps their income from the premium.
Is cash secured put a good strategy for stock buying?
Cash secured puts can be a good strategy for buying stocks in certain instances. It is an excellent strategy that you can use to buy stocks that you are bullish about in the long term, but are estimated to drop a little in the short term.
How do I calculate max profit, break-even and max loss in cash secured put options?
The maximum profit in a cash secured put is the premium received after subtracting the commissions and other fees. The break-even point is the price at which you would start incurring a loss. The maximum loss describes the situation wherein you are purchasing the underlying asset at the strike price and the stock price falls to zero.
What is the difference between cash secured puts and covered puts?
A cash secured put is a stock acquisition strategy based on the prediction of a bullish market in the long term. However, a covered put is used when the trader predicts a bearish market.