Who Should Consider Selling Cash-Secured Puts?
- An investor who would like to acquire shares in a particular security, but is willing to wait for them to trade at a target price that is below current market level
Have you ever entered a limit order to buy a security at a price below its current trading level? If so, you've most likely experienced a waiting game, and possibly a lengthy one because the stock will not be purchased until it trades at or below your limit price. Instead of simply waiting for that to happen you could take an approach that is a little more pro-active and sell (write) a cash-secured put. You will be paid, in the form of the premium received for selling the put, in return for accepting the obligation to buy underlying shares if assigned, and at a price lower price that you select in advance. Many large portfolio managers as well as individual investors find this an attractive means to acquire stock for their portfolios.
An investor who employs a cash-secured put writes a put contract, and at the same time deposits in his brokerage account the full cash amount for a possible purchase of underlying shares. The purpose of depositing this cash is to ensure that it's available should the investor be assigned on the short put position and be obligated to purchase shares at the put's strike price. While the cash is on deposit it may generally be invested in short-term, interest-bearing instruments.
The net price paid for underlying shares on assignment is equal to the put's strike price minus the premium received for selling the put in the first place. For this reason, the strike price chosen, less the premium amount, should reflect the investor's target price for acquiring underlying shares. Regardless of the direction the stock price takes after the put is sold, or whether assignment is received or not, the put seller keeps the premium.
On the downside, the break-even point for this strategy is an underlying stock price equal to the put's strike price less the premium received for selling it. If the stock declines significantly below the strike price by expiration, on assignment the investor may be obligated to purchase shares well above their current price level. Stock bought under this circumstance may therefore reflect a loss compared to its market price at the time. However, this loss would be unrealized as long as the investor holds the shares and is positioned to profit from an increase in their price. Any investor whose motivation in writing a cash-secured put is to buy underlying stock should therefore be committed in advance to a target price for a possible purchase, and select a strike price accordingly.
On the upside the risk is one of opportunity loss. After selling the put the underlying stock price can go up and remain above the put's strike price. In this case, neither a put seller who is not assigned, nor an investor who originally entered a low limit order for the stock instead, will buy the stock. The put seller, however, keeps the put sale premium received.