If you keep enough cash on-hand, not only are you prepared in the event of an assignment, but you’ve tapped into a method to buy stock that may also earn you a little extra income along the way. Let’s explain with an example.
Imagine you like stock XYZ at $52, but you’re not looking to jump right in and buy. If the stock did come down a little, you’ve decided you’d be willing to buy 100 shares. So you’d sell one 50-strike put with an expiration date 45 days away, and you’d collect a premium of $3 per share, or $300 for the contract. At the same time, you’d set aside $5,000 in cash, in the event that you’d be assigned on your put sale. The cash would secure the trade and cover you if you're obligated to buy shares at your strike price via assignment. Setting aside this cash protects you against the unlimited-risk horror scenario that the naked put seller would’ve faced upon assignment.
The ideal scenario would be if the stock falls slightly below $50 at expiration. The owner of the put would exercise and you’d likely be assigned. You’d use your $5,000 in cash to buy the stock at $50. At the end of the day, you’d be long 100 shares at $50, just as you wanted - plus you’d earn $300 in extra income, for a net cost basis of $47 per share (plus total costs of $10.55 for the commission and assignment fee of the put).
Another good scenario would be if the stock remains above $50. It’s unlikely you’d be assigned on your put, but you’d still get to keep the premium of $300 as income ($294.40 after commissions). Not a bad result for the stock not performing as you had hoped.
A third scenario shows the downside of this strategy. In this case, after you short the put, the stock drops drastically, much further than the couple of bucks you expected. We discuss this in the next section.
What are the risks of cash-secured put selling?
You could miss a big run-up in the stock. If you’re bullish in the short term and you want to capitalize on immediate gains, cash-secured put selling may not be the way to go. After all, there’s no guarantee that you’d get assigned. Furthermore, because assignment is necessary in order for you to buy the stock, you’d need a short-term dip in the stock price, followed by a longer-term rise once you own the stock.
A more grave risk would be if the stock took a dive after you sold your put. In this case, you’d likely be assigned and become a shareholder. However, the stock would be trading so much lower that you might rethink whether you should own it in the first place. If you hadn’t gotten assigned at this point, the short put would show a significant loss. Regardless, the worst-case scenario is if the stock tumbled to zero. You’d be on the hook for roughly $4,700 ($5,000 less the $300 premium plus costs of $10.55).
If you know the risks, you’re mildly bearish short-term but bullish long-term, and you can be patient about when to open a long position, writing cash-secured puts may present an intriguing alternative to an outright stock purchase.
Let's go trade some puts
Since puts give you the right to sell stock at a predetermined price, they are sometimes regarded as a purely bearish instrument. As we’ve shown here, that’s clearly not the case. Puts can come in handy no matter what your outlook is.
Bullish investors can use puts to protect gains in times of market uncertainty, to generate income, or to try to acquire stock at a discount in the event of a dip in price. And, of course, bearish investors may buy puts instead short selling stock.
But be careful. As with any other option strategy, trading puts involve risk. After all, options are never a sure thing. So you need to understand your risks and rewards and enter the trade with a plan for all possible outcomes.