Cash-secured put selling: a way to earn income and limit risk.

In this series on put options we've discussed what puts are and two common uses for them:  protecting profits on an existing position and as an alternative to short-selling. In today's post, I'd like to introduce you to cash-secured put selling as a means of earning income above and beyond dividends paid by stocks.

What is the Options Guy talking about? Selling puts is RISKY! Yes, you may've heard horror stories about naked put selling: you sell a put, meaning the other person now has the right to sell stock to you at the strike price of the option. Let's say you "normally" like to buy stock in smaller blocks of 100 or 200 shares, but because the margin requirement was low you decided to sell 20 puts to bring in a little extra income. In this instance you would be considered naked 20 puts, representing the obligation to buy 2000 shares. The problem is you don't have all the cash needed to buy that stock if you are assigned. If the stock does decline more then expected and the person exercises what do you do? In this instance you are forced to buy the stock at the higher price strike price and sell at the current market price, which could mean substantial losses. This way of selling puts is pure speculation and is what dives the horror stories about large losses selling puts.

There is another way to approach put selling: cash-secure your puts before you sell. If you have the cash on-hand, not only are you prepared for the assignment, but you've tapped into a way to buy stock that also earns you a little extra income.

Here's how it works: you like a stock called XYZ at 52, but you're not looking to jump right in. If it did come down a little you have decided that you would be willing to buy 100 shares. So you sell 1 April 50 put, earning a premium of $2, or $200 for the contract. At the same time, you set aside $5000 in cash, in the event that you're assigned. When the exercise comes, you simply use that $5000 to buy the stock at 50. At the end of the day, you're long 100 shares at $50, just as you wanted -- plus you've earned $200 in extra income, for a net cost basis of $48. Naturally if the stock is currently below $48 losses will occur, but remember you almost bought it at $52.

On the flipside, if you're bullish and want to be sure you buy now; cash-secured put selling may not be the way to go. It's not guaranteed that you'd get assigned and buy the stock so handily. At the same time, if you're mildly bullish and patient about when you open a long position, put-selling can present an intriguing alternative to straight buying.

If you've been writing covered calls on stocks that you own, the next natural step for many new options traders is sell the put cash-secured to help with the purchase of the stock. These two strategies compliment each other well.

Tell us about your experiences, too! If you've tried any of these strategies and wanted to share a question or observation about it, I'd love to hear your comments.

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.