This blog focuses mainly on selling cash-secured put options, an income-producing options strategy that’s the technical equivalent of a covered call strategy (a very conservative options strategy in which you sell call options against shares of stock you already own), except it uses put options and doesn’t involve owning the stock beforehand (also called “naked put selling”). Selling a put option is very much like placing a limit order to buy a stock at a price below the market – except in this case you’re getting paid to do so, whether you eventually end up buying the stock or not!
What’s a cash-secured put?
Selling a cash-secured put option basically means you’re selling someone the right (or option) to sell you a stock at a certain strike price (usually below the current market price) any time between now and when the option expires. As the seller of the option, you immediately collect – and keep – the premium from the put option sale as income in your account, regardless of what happens next. The put option(s) you are short is considered “cash secured” if you have enough cash in your account to pay for the shares of the underlying stock if they’re ultimately put to you.
If the stock stays where it is or goes higher into the option’s expiration, the put expires worthless (the buyer loses) and that’s that – your obligation to potentially buy (be put) the stock has ended as well, and it’s on to the next trade. If the stock drops and is below the strike price at expiration, you can expect to be “put” the stock at the strike price at which you sold the put option (unless you buy the put option back beforehand or take other action (see below)).
A “win-win” situation
I try to make this a “win-win” situation by only selling puts on stocks I’m interested in owning – usually quality, dividend-paying stocks – at prices I’m willing to own them at. I usually try to have several of these options positions expiring each month, becoming more aggressive when the market is lower (as downside risk decreases) and less so as it goes higher. The vast majority of the time the options expire worthless, so I’m almost always constantly in a cycle of adding new positions while watching other older positions expire, all the while adding incremental income to my account.
This strategy (used intelligently) will make money in most market environments (up, slightly down, sideways). Generally speaking, it can produce consistent double-digit annualized gains based on the individual trades while incurring less risk than owning the underlying stocks (although the flexibility of options allows the risk/return to be adjusted up/down depending on one’s risk tolerance).
However, a significant market decline could mean being put the underlying stocks at significant losses (although this would still be outperforming a strategy of simply owning the stocks). In this situation, “rolling out” an option position to a later date and lower strike price (by buying back the put option(s) you are short and selling a later-expiring option(s) to offset the cost) is usually available as an alternative to being put a stock, demonstrating the huge advantage in flexibility that options offer as trading/investing tools.
The downside to selling puts
Selling cash-secured puts has two main drawbacks: First, since most of the options sold are short term (less than one year to expiration), the gains are taxed at a higher rate as short-term capital gains. The exceptions to this would be selling LEAPS (Long-term Equity AnticiPation Securities) with a year or longer duration, and trades made within a tax-deferred retirement account. (Most brokers will allow cash-secured put selling in a retirement account. Those that won’t aren’t worthy of further consideration, IMO.)
The second potential drawback is that while this strategy will outperform in most market environments, it will tend to underperform, in terms of total return, a very strong bull market (i.e., one that produces annual returns significantly above 20%+). As my investing/trading goals are more income oriented than total return oriented, this isn’t a matter of priority for me. Also, since I’m almost always long some stocks in my portfolio, I’ll be participating to a greater or lesser degree in such market moves anyway.
The bottom line is that selling cash-secured puts (and covered calls) can offer income-oriented investors/traders a conservative approach for generating income and reducing risk in any market environment.