A cash-covered put is a 2-part strategy that involves selling an out-of-the-money put option while simultaneously setting aside the capital needed to purchase the underlying stock at the option’s strike price. The goal of this strategy is to acquire the stock at lower than the current market price if the option gets assigned to you.
When and why to use cash-covered puts
Have you ever entered a limit order to buy a stock below its current trading price, only to find yourself waiting around for the price to drop for your order to execute? Wouldn’t it be nice if you could make some money in the meantime? With a cash-covered put, you may be able to.
By selling a cash-covered put, you can collect money (the premium) from the option buyer. The buyer pays this premium for the right to sell you shares of stock, any time before expiration, at the strike price. The premium you receive allows you to lower your overall purchase price if you get assigned the shares.
But what happens if you are not assigned the shares on or before expiration? You keep the premium. While your intention may have been to own the stock, at least you received some incentive for waiting around for the stock to drop in price.
Step 1: Setting cash aside
As the put seller, there’s a chance you may be assigned shares if the put buyer exercises the option. When this happens, you’re assuming ownership of the underlying stock at its strike price. Setting aside the cash for this transaction ahead of time allows you to prepare for this scenario.
Remember that 1 option contract equals 100 shares of the underlying stock. So you’d have to multiply the strike price by 100 times the number of contracts in order to figure out the amount you should be setting aside.
Step 2: Selling a put option
Selling a put option allows you to collect a premium from the put buyer. Regardless of what happens later on in the trade, as the put seller, you always get to keep the premium that is paid up front.
Compared to buying a stock outright, in which you’d pay the current market price and have guaranteed ownership, selling a put option allows you to generate some income and potentially own the stock at a lower price.
Profit and risk potential
With cash-covered puts, the profit potential has 2 components: the option trade, and if the stock gets assigned. The most you can make from the option trade is the premium. If the stock is assigned and you are given ownership, your upside is potentially unlimited if the stock moves higher.
Cash-covered puts also have substantial risk because, if shares of the underlying stock fall below the strike price or even go all the way down to $0, you will still be obligated to buy shares at the original strike price. You can see how the risk involved with a cash-covered put differs from using a limit order to buy a stock.
Example
Here's an example of a cash-covered put in action. The option in question looks like this:
Sell 1 XYZ Dec 50 put @ 2.30 to open
in other words, you're selling 1 contract representing 100 shares of stock XYZ, and will be obligated to buy that stock if the party who purchased this contract decides to exercise their option. With contracts on individual stocks, this could happen at any time, and it normally occurs when XYZ is at or below $50 per share. By entering into this contract, the buyer will pay you a premium of $2.30/share ($230 total for the contract).
If, at expiration, the stock is worth more than $50 per share, the put option more than likely expires worthless, and you get to keep your premium. You are not required to buy 100 shares of XYZ, so you do not participate in any additional profits if the stock continues to rise above $50.
If the stock is less than $50 at expiration, then the contract will more than likely be assigned and you will buy 100 shares of XYZ. Shares will be automatically purchased for you at the strike price of $50, but since you received $2.30/share from selling the contract, your effective purchase price is $47.70/share. As the option portion of the trade is now completed, your gain and loss now will be based on the movement of XYZ shares above or below your purchase price.