The derivatives contracts like futures and options are not only used for hedging the equity position but also to generate a regular income from it. Many traders and investors use their holdings and balance margin to initiate trades by combining futures, call options, and put options to derive regular income from the stock market.
In this blog, we will look at how a strategy of selling cash secured puts can be utilized to earn some income from the stock market.
What are cash secured puts?
The cash secured put selling is a type of option selling strategy that involves setting aside enough money to buy a stock at a set price while you sell the put option of that strike price. The goal is to buy the stock below the current market price.
There are certain risks involved with this though. The first risk is that the price may never fall to that level where the trader is looking to buy the stocks. This could lead to a loss of opportunity to buy the stocks for the long term. And the second risk is that the stock price could plummet way below the strike price. This could put traders into a situation of fear.
Advantages of Selling Cash Secured Puts
Following are some of the many benefits of this strategy.
Collect Premium
Cash secured puts are usually sold to get the option premium. The amount that you get depends on the security and the price you’re willing to buy.
Quick Reinvestment of Gains
Cash secured puts can provide immediate cash flow. Not only can it make option income more attractive, but it can also help minimize risk.
Get Paid for Investing
A cash secured put strategy is an excellent way to get paid for investing in the desired stock. There are numerous strike prices and expiration dates available for this strategy.
Can Earn from Low Dividend Stocks
If you are looking for a way to increase your cash flow without being limited by a low dividend yield, then selling cash secured puts is a method that can help you.
Disadvantages of Selling Cash Secured Puts
Well, you have seen enough benefits of this strategy so far and how it works. Let us now look at some of the downsides of this strategy.
Trade in Multiple of Lot Size
The derivatives like futures and options are traded in multiple lot sizes only. If you are looking to buy stocks in a very small quantity or fraction of the lot size, then this method will not be helpful to you.
Possibility of Missing the Opportunity to Buy
The cash secured put strategy is not suitable for most investors who want to eventually own shares in a company. If the share price remains high, they may never own shares.
No Benefit of Dividends
Since you do not own the shares yet, the question of earning a dividend on them does not arise. You get paid for this with an upfront premium, but it remains your only cash flow until it expires.
Repetitive Process
A simple buy-and-hold strategy is more attractive to most investors. This strategy involves selling cash secured puts to buy stocks when the buyer of put options exercises the right to sell. Since the option does not have to be mandatorily exercised, it is more time-consuming to implement to repeat the process for every expiry.
Tax Implication
The tax on income earned by selling cash secured puts is considered as business income and is liable to tax based on slab applicable to the trader. If the trader owned the stock, income would be by way of dividend and capital appreciation which could together attract a comparatively lower tax rate.
Understanding with an Example
Suppose there is a Stock XYZ currently trading at Rs. 500. The lot size of the derivatives contract of Stock XYZ is 100 shares and you wish to buy the 100 shares of XYZ at Rs. 470.
You can earn income by selling the put option of 470 strike price each month and collecting the premium. Suppose, the premium for 470 put options for the current month is Rs. 8. When you sell that put option, you collect Rs. 800 (Rs. 8 x 100 shares).
This implies that you are willing to buy 100 units of the stock XYZ for Rs. 470 at the end of the expiry if the price at that time is Rs. 470 or below. To secure this obligation to buy, you need to maintain the balance of Rs. 47,000 (Rs. 470 x 100 shares) in your account.
If the stock price ends up anywhere above Rs. 470, you get to keep the whole premium collected on selling the 470 strike price put option.
The Bottomline
Cash-secured put selling is a strategy that involves buying a security at a price that you would agree to pay. This method works for people who are looking to enhance their cash flow or own security at a fair price. You might be disinterested in selling cash secured puts due to the complexity of the transaction and the fear of owning the security. For the investors and traders looking to generate some passive income from the stock market, this strategy could be more helpful.
