Stock markets are no rocket science once you start to understand the financial instruments it offers and how each instrument functions. Upon knowing the functionality of various instruments, you can utilize them in your favour time and again as the opportunity arises. Successful traders and investors have been doing this for decades. Thanks to the improved investor awareness, we are now learning from watching videos and reading blogs about how, conventionally, big players have been minting money from the financial markets.
Selling a cash secured put is one such way by which you can not only lock your opportunity to buy your favourite stock at the desired price level but also to make sure that if the stock does not come down to your level, how you can earn some income by way of collecting the premium.
To understand cash secured puts, let us start from the basics by first understanding put options.
What is Put Option?
A put option is a contract where the buyer can sell a particular security at a set price within a certain period or expiration. From the perspective of the seller, a put option is a contract where the seller should purchase the shares at the agreed price that is the strike price on the date of expiry.
What is a Cash Secured Put?
Cash secured put is when you sell the put option and have a balance of cash secured for buying the stock at the strike price. Suppose, the strike price of Rs. 100 put is sold and lot size is 500 shares, then a cash balance of Rs. 50,000 must be available in the trading account while you are selling the put option. This is called cash secured put.
What does the selling Put Option mean?
Selling a put option is also called ‘Put Writing’ or ‘Put Shorting’. It is a strategy that involves selling a put contract and collecting the premium from the buyer. Premium is a cost to the buyer whereas it is an income for the seller.
If the stock price falls, the seller loses money and if the stock price goes up, the seller gets to keep the premium and the maximum loss for the buyer would be the cost of premium paid.
Three possible scenarios can happen on the day of the expiry of put contracts.
Stock price ends up above the strike price:
In that case, the seller keeps the whole premium amount and the buyer registers that amount as a loss.
Stock price ends up below the strike price:
In this case, the buyer will gain a sum equivalent to the difference between the strike price and closing price minus the premium paid. On the other hand, the seller will have to buy the stocks at a price agreed upon, that is, the strike price.
Stock price ends exactly at the strike price:
In this case, the buyer undergoes loss equivalent to the premium paid and the seller can keep the premium and then buy the stock at that price on the expiry date.
What is Cash Secured Puts Selling?
- The cash secured put is a type of options trading strategy that involves setting aside money to purchase a stock at a set price.
- The goal is to expect the stock below the current price at expiration.
- The investor hopes that the stock will decline in the near term. If it does, the put may be assigned to lock in the investor’s gains.
Understanding Cash Secured Puts with an Example
Suppose you are looking forward to purchasing the stock PQR at Rs. 200. The current market price of the stock is Rs. 220. Let us assume that the 200 strike price put option is trading at Rs. 5 and the lot size of stock PQR is 300 shares.
Since you want to buy the stock at Rs. 200 which is currently trading at Rs. 220, you sell a 200 strike price put option at Rs. 5. At the same time, you maintain a cash balance of Rs. 60,000 (Rs. 200 x 300 shares per lot) in your trading account. In this process, you collected the premium of Rs. 5 per share, totalling Rs. 1,500.
If the stock price goes down to Rs. 200 or below, you can purchase 300 stocks by paying off Rs. 60,000 cash. Since you collected the premium of Rs. 1,500, your effective cost of 300 shares comes to Rs. 58,500 only.
Whereas, if the stock price does not come down and expires above Rs. 200, then the contract expires and you get to keep Rs. 1,500 as income and cannot buy the shares.
Prerequisites for using this strategy
To be able to utilize the benefits cash secured puts have to offer, you need to ensure the following prerequisites for the same.
- The stock must belong to the F&O segment, meaning it must have derivative contracts like futures and options trading on the stock exchanges.
- You have enough balance of funds to your credit to purchase all the quantities in the lot size at the agreed strike price.
- Ensure that the stock exchanges have not included derivatives of that stock in the list of F&O ban stocks.
What are the Risks involved with Cash Secured Puts?
There are some drawbacks and risks involved in this strategy of selling cash secured puts. Let us take a look at them.
- If you’re a long-term bull and you’re thinking of selling stocks for immediate gains, then selling a cash secured puts may not be the way to go. It’s not the same as buying stocks cheaply.
- If the stock price went down after you sold your put, it would be a risky move. The stock would still lose a huge amount of money.
In Nutshell
Since puts are often regarded as a bearish instrument, they are sometimes considered to be an inferior tool to stocks. Bullish investors use puts to protect their gains in times of market uncertainty and to generate income. If you’re not sure about the risks, writing cash secured puts could be an alternative for you to buying stocks.
