If you are planning on making a big purchase, but you think the item may go on sale in a week, what would you do? Buy now? Wait and see? How long would you be willing to wait for the price to drop? What does the price need to be before you buy? Are you willing to risk the price going up by not buying right away?
These questions are also applicable to investing, especially when buying stock in a company. And if you want to own a stock but don’t want to buy it outright, there’s another method many investors use-options.
Options are popular tools used by investors who want the versatility to potentially buy or sell shares at some point in the future. This article will outline one of the more common options strategies: cash-covered puts.
What is a cash-covered put?
A cash-covered put is a two-part strategy that involves selling an out-of-the-money put option while simultaneously setting aside the capital needed to purchase the underlying stock if it hits the option’s strike price. The goal of this strategy is to acquire the stock at a lower price than the market’s offering if the option gets assigned to you.
If you’re not familiar with put options and how they work, it’s explained in a short video here.
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 can.
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 the stock never reaches the strike price by 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.
Part 1: Setting cash aside
As the put seller, there’s a chance you may be assigned shares when 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 one put option contract equals 100 shares of the underlying stock. So you’d have to multiply the strike price by 100 in order to figure out the amount you should be setting aside.
Part 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 generate some income and potentially own the stock at a lower price.
Profit and risk potential
With cash-covered puts, the profit potential has two 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 as the stock moves higher.
Cash-covered puts also have substantial risk because, if shares of the underlying stock fall 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.
A practical 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 one contract (100 shares) on 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, regardless of the price of XYZ; however, it would normally occur once XYZ hits $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 expires worthless, and you get to keep your premium.
If the stock is less than $50 at expiration, then it will be assigned.