(1) To buy stock below the current price or (2) to earn a reasonable return on the cash deposit without taking risk greater than owning stock.
Investors who sell cash-secured puts generally are willing to buy the underlying shares of stock. Rather than buy the shares at the current price, however, they hope the put will be assigned and the shares will be purchased at a lower price.
In return for receiving a premium, the seller of a put assumes the obligation to buy the underlying stock at the strike price at any time until the expiration date. Stock options in the U.S. typically cover 100 shares. Therefore, in the example above, the investor receives $3.00 per share ($300 less commissions) and assumes the obligation to buy 100 shares of XYZ stock at $100 per share until the expiration date (usually the third Friday of the month). The net premium received can be used to purchase the shares, so the investor also deposits $97 per share ($9,700) cash in a money market account which, along with the $300 option premium, will be used to pay for the 100 shares of stock if the put is assigned.
If the stock price is below the strike price at expiration, then the put will be assigned. As a result, the investor will buy the shares and pay for them with the cash held in the money market account plus the option premium. If the investor still wants to own the stock, then the investor need do nothing. However, if the investor no longer wants to own the shares, then the stock must be sold. Alternatively, the investor could close the obligation to buy shares by buying the put in the market place prior to expiration and before an assignment notice is received.
If the stock price is above the strike price of the put at expiration, then the put expires worthless and the premium is kept as income. The investor must then decide whether to buy the stock at the current price or to sell another put or to invest the cash elsewhere.
Example of short put - cash secured
Sell 1 XYZ 100 Put at 3.00 per share ($300 less commissions) Hold cash (or money market account) of $97.00 per share ($9,700 for 100 shares)
The potential profit is limited to the net premium received.
Risk is substantial, because the stock price can fall to zero.
Breakeven stock price at expiration
Strike price minus premium received.
In this example: 100.00 − 3.00 = 97.00
Profit/Loss diagram and table: Short 100 Put @ 3.00
|Stock Price at Expiration||100 Put Sale Price||100 Put Value at Expiration||Profit/(Loss) at Expiration|
Appropriate market forecast
Selling a cash-secured put requires a neutral-to-bullish forecast. If the stock price remains unchanged or rises, then the price of the put will decline.
Selling a cash-secured put has two advantages and one disadvantage. First, if the stock is purchased because the put is assigned, then the purchase price will be below the current price. Second, selling a put brings in premium (cash) which is kept as income if the put expires worthless. This contrasts with a limit-price buy order which earns nothing if the order is not executed. The disadvantage of selling a put is that the profit potential is limited. If the stock price rises sharply, then the short put profits only to the extent of the premium received.
The choice between (1) buying stock today and (2) selling a cash-secured put today and holding cash in reserve is a subjective decision that investors must make individually.
Impact of stock price change
Put prices, generally, do not change dollar-for-dollar with changes in the price of the underlying stock. Therefore, an investor who sells a cash-secured put will typically make or lose less than the owner of 100 shares of stock as the stock price fluctuates.
Put options change in price based on their “delta,” and put options have negative deltas. At-the-money puts typically have deltas of approximately −50%, so a $1 fall or rise in stock price causes an at-the-money put to rise or fall by approximately 50 cents. In-the-money puts tend to have deltas between −100% and −50%. Out-of-the-money puts tend to have deltas between −50% and zero.
Impact of change in volatility
Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. As a result, short put positions benefit from falling volatility and are hurt by rising volatility.
Impact of time
The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. Short put positions benefit from passing time if other factors such as stock price and volatility remain constant.
Risk of early assignment
Stock options in the United States can be exercised on any business day, and the holder of a short option position has no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered. However, since sellers of cash-secured puts are generally willing to buy the underlying shares, the possibility of early assignment should not be of great concern. Early assignment of a cash-secured put simply means that stock is purchased prior to the expiration date. Also, early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date.
Potential position created at expiration
If a put is assigned, then stock is purchased at the strike price of the put. If there is no short stock position, then a long stock position is created.
When cash-secured puts are sold it is assumed that the investor is willing to buy the underlying stock. Therefore, the risk of early assignment is not a big concern. Also, since puts are automatically exercised at expiration if they are one cent ($0.01) in the money at expiration, an investor who sells cash-secured puts and wants to buy the stock need take no action if the stock price is below the strike price at expiration.
However, if the stock price is above the strike price at expiration, then a decision must be made. Should the stock be purchased at its current price? Or should another put be sold? Or should the cash held in reserve be invested elsewhere? This is a subjective decision that investors must make individually.