Cash Secured Put Option Strategy
A cash secured put option strategy is selling a put at a certain strike price while simultaneously posting cash as collateral in the event the put option is exercised and shares are obligated to be purchased. An investor with an investment objective of income sells cash secured puts to receive the option premiums. A cash secured put option strategy requires a moderate level of risk tolerance.
The risks to this option strategy is that the investor may be forced to buy the stock at a higher price then what it’s currently worth. This means that the value of stock you’re obligated to purchase may even fall to zero. Additionally, the short-term unrealized loss on a cash secured put can exceed the cash collateral value. An investor who has a neutral to bullish outlook on a stock that anticipates the price to not trade below a certain level for a duration of time generates income by selling a cash secured put option.
Let’s See an Example:
An investor anticipates that stock EIO which currently trades at $8 will remain higher for the foreseeable future. The investor sells 1 put option with a strike price of $8 for $3 with a three-month expiration. The investor is also required to post $800 of cash as collateral in case the put is assigned so he can make good on paying for 100 shares at $8.
• Sell 1 EIO put option at the $8 strike price with 3 months until expiration date for a premium of $3
• Long $800 of cash as collateral
The maximum gain is the premium of $300 which the investor collects for selling the put. This is calculated as follows:
Maximum Profit per Option = Premium x 100 shares
$300 = $3 x 100 shares
In the event that stock falls to $0 before expiration date and the option is assigned, the investor will be required to purchase the stock for $8. This would result in a maximum loss of $500, which is the $800 loss from the stock less then $300 premium received from selling the put option. This is calculated as follows:
Maximum Loss per Option = (Stock Purchase Price - Premium) x 100 shares
$500 = ($8 - $3) x 100 shares
The breakeven point is the strike price of the put option less the premium received. This is calculated as follows:
Breakeven Price = (Short Put Strike Price - Premium)
$5= $8 - $3
The profit and loss of the cash secured option strategy until expiration date is depicted below.
The chart shows the potential profit and loss on the y-axis versus the corresponding stock price in the x-axis until expiration date.
After three months if the price of EIO stays above $8 the investor keeps the $300 in premium. Conversely, if the share price falls to $0, the investor is obligated to purchase 100 shares at $8 using the $800 set aside as collateral. The investor will lose $500 in total, as the premium received from the sale of the put option off sets the $800 loss from the stock.
If the price of EIO is between $5 and $8 before expiration date, the investor may be assigned and be obligated to buy shares of EIO at $8 for a total of $800. However, since the investor collected $300 premium from the sale of the put option, there is still profit potential between $0 and $300. In this scenario, an investor can acquire a stock at a lower price while also profiting from the sale of the put premium.
The downside risk if is the stock price of EIO falls between $5 and $0, the investor may be assigned and forced to buy the stock at $8 while it’s worth much less. The unrealized losses could be between $0 and $500 depending on current price of EIO.
