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One may use the stock market to create a consistent income stream along with future investments. For example, futures and options contracts and other derivatives allow investors to protect their stock holdings and consistently profit from them.
Many traders and buyers use their assets and margin balance to trade futures, call options, and put options together to make steady money on the stock market.
Today, we’re going to talk about one such option strategy known as cash-secured puts and how to make money on the stock market by selling them, with examples.
What are puts and how puts work?
A put option is an option contract where the seller establishes the conditions and the purchaser pays a premium for each share. In return, the buyer gets the option, but not the responsibility, to trade a security at a strike price within a particular amount of time, known as the expiration.
Hedging and speculating are two possible uses for put options. However, the fundamentals are as follows: a put’s value rises when the underlying stock price falls, and a put’s value falls when the underlying stock price rises.
You may purchase or trade the underlying stock at the strike price if the price of the stock on the market changes in your favour. You may execute the American-style option up to the expiration date. On the contrary, in the European style, the option needs to be executed on the expiry date.
A put seller might profit from the premium they paid if the underlying equities’ market price remains the same or goes up. You need to pay the seller the strike price to repurchase the option if the market price drops.
What are cash-secured puts?
A cash-secured put is a way to sell options to purchase a stock at a price lower than its present market value. With this approach, a trader sets aside the money to purchase a stock at a particular price and then writes a put option.
To execute a cash-secured put, one must first gather sufficient funds to buy the asset in question while simultaneously selling a put option.
The buyer may pay a premium to the investor in this situation. The simplest explanation is that an investor gets a premium when they agree to buy an asset at a lower value than the present strike price.
Most of the time, the investor still wants to buy the asset but the ideal situation is to be able to buy at the strike price.
There are, however, some risks that come with this. This trader could lose money if the price of the stock never goes down enough for them to buy it. The second potential downside is an abrupt drop in stock price below the strike price.
How to sell cash-secured puts to earn an income? With example
Here’s a hypothetical scenario of how to write cash secured puts in a step-by-step manner:
- Stock ABC is trading at ₹700.
- Say you’re interested in purchasing 100 shares of ABC for ₹680 and earning 9 rupees per share as a premium by selling a put option with a strike price of 680 rupees.
- The total premium you will earn is 900 rupees, ( ₹9 x 100 shares).
- If the stock price at expiry is at or below the strike price, you are required to purchase 100 shares of ABC at ₹680.
- To cover this potential purchase, you set aside ₹68,000 ( ₹680 x 100 shares) in your account.
- At expiry, the put option becomes worthless if ABC stays above ₹680, and you get to retain the ₹900 premium.
Cash secured put vs covered call
| Aspect | Cash-covered put | Covered call |
| Definition | An investor will use this options method to their advantage by writing a put option and funding it with cash, so they may buy the stock if it’s assigned. | In this strategy, the investor has legal ownership of the stock and sells a call option against it to earn premium income. |
| Position | Even if the investor doesn’t get ownership of the stock when they purchase the option, they still need the funds on hand to actually purchase it. | The investor already owns the underlying stock and writes a call option on that very stock. |
| Risk | Risk is limited to the strike price minus the premium received if the stock price drops below the strike price. | The only thing that could go wrong is the loss in the value of the stock minus the fee that was paid. |
Conclusion
To purchase equities at a discount to their present price, you might use the cash-secured put option selling approach. This method works well for stocks that you want to acquire in the long run. Additionally, you may earn additional income via premiums. However, remember to keep the associated risks in mind as well before trying this strategy.
FAQs
A cash-secured put is generally considered a bullish to neutral strategy. It involves selling a put option to buy the underlying stock at a lower price while having the cash to cover the purchase. This strategy is used when an investor is willing to own the shares at the strike price, expecting the stock to not fall below it. If the stock remains above the strike price, the investor profits from the premium received.
The disadvantages of cash-secured puts include the potential for significant losses if the stock price falls well below the strike price, as the investor is obligated to buy the stock at the strike price, which could be higher than the market value. There’s also the opportunity cost if the stock price rises significantly, as the investor misses out on the gains beyond the premium received. Additionally, this strategy requires a substantial cash outlay to cover the potential stock purchase, which could be used elsewhere.
Selling cash-secured puts is typically done when an investor is looking to purchase a stock at a discount to the current market price and is willing to wait for the stock to drop to the desired level. It is also a strategy used when market volatility is high, as this increases the premium received. The ideal time to sell cash-secured puts is when the investor has a neutral to slightly bullish outlook on the stock and would not mind owning it if the put is assigned.
The main difference between covered puts and cash-secured puts lies in the position of the underlying stock. In a covered put, the investor short sells the stock and simultaneously sells a put option, aiming for a decline in the stock’s price. It’s a bearish strategy with unlimited risk. In contrast, a cash-secured put does not involve short selling; instead, the investor sells a put option and secures cash to potentially buy the stock at the strike price, reflecting a bullish to neutral outlook with limited risk.
Whether puts are better than calls depends on the market view and investment strategy. Puts are considered better when an investor expects a decline in the stock price and wishes to profit from it or protect against a downturn in a long position. They can also be used to generate income through premiums when selling cash-secured puts. Calls are preferred when there’s an anticipation of a rise in the stock price.
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