Wondering what’s the best strategy for selling put options? Retirement is a subject that is on the minds of pretty much everyone; one day, we all hope to have enough assets saved up so that we will no longer have to work. Of course, accumulating assets for retirement is only half the story. Once we actually do retire, we need to find a way to ensure that the assets we have will last for the remainder of our lives.
With this quandary in mind, many investors gear their accounts in retirement to focus on income; using the assets that they already own to generate consistent revenue on the funds, effectively replacing the paycheck that they previously earned when employed. There are a number of different ways to generate income on an investment account. One of the most popular is through the selling of equity options, the most common of which are covered calls and cash secured puts.
In this article, we are going to focus specifically on cash secured puts, discussing what they are and how an investor can potentially use them to generate income for their own retirement or investment account. With the right strategy, selling cash secured puts represent a prime opportunity for many investors.
What are Cash Secured Puts?
Let’s begin our discussion by defining what exactly cash secured puts are. Cash secured puts are an equity option; this means that they represent a contract between two parties to sell a quantity of shares of an underlying stock at a predetermined price (the strike price) on or before a specified deadline date (the expiration date). One party in the contract sells the option, while the other party buys it.
In a cash-secured put, the party in the transaction who sells the contract receives a payment of cash (a premium) from the buyer of the option. In exchange for this premium, the buyer receives the right (but not the obligation) to exercise the put prior to the expiration date. If the buyer decides to exercise the put, they will sell 100 shares of the underlying stock position to the option seller. The seller of the cash secured put is obligated to buy the shares at the strike price. If the buyer decides not to exercise the put option by the expiration date, the option will simply expire with no further transaction taking place. The seller of the cash secured put keeps the premium in both scenarios.
Similarities to Covered Calls
Cash secured puts are often compared to another type of equity option, covered calls. Indeed, the two types of options do share quite a few characteristics. Covered calls also represent a contract between a buyer and a seller; the seller receives a premium while the buyer receives certain rights. Both options have a strike price that the transaction of the underlying stock will take place at if the buyer chooses to exercise the option; both also have an expiration date that the buyer of the option must exercise it by.
The primary difference that exists between covered calls and cash secured puts concerns the actual transaction that takes place, particularly with respect to the buyer of the option. The buyer of a covered call has the right to purchase shares of the underlying stock at the strike price, while the buyer of a cash secured put has the right to sell shares at the strike price.
Both strategies offer an excellent opportunity to generate additional income from a stock portfolio. Because they are both lower risk option strategies, they are a great way for new investors to learn more about options.
Important Considerations When Selling Cash Secured Puts
When selling put options, there will be some other factors that a seller will want to be knowledgeable of as part of their strategy.
Put Options Expiry Dates
When selling cash secured puts, a trader will want to keep apprised of a couple of different factors. One of the primary ones is the format of the expiration date of the option. Traditionally, equity options (like cash secured puts) were sold for a single expiration during a given month. This was usually the third Friday of the month. Indeed, many (if not most) options that are still sold today are sold for these once-monthly expiration dates. All optionable stocks will have at least a monthly expiration date.
In recent years, however, brokerages have introduced the concept of daily and weekly options. These options represent further opportunities for investors to earn income.
The strike price is a key factor that should be considered when selling cash secured. Many puts are sold out-of-the-money; that is, they are sold for a strike price that is slightly lower than the current market price of the underlying stock. This is usually done to decrease the potential risk of having the option exercised.
Selling a put that is in-the-money (i.e. for a strike price higher than the current market price) can earn the seller a greater premium on the transaction. But, it also increases the risk that the put will ultimately be assigned. A seller will, in many cases, want to avoid this.
The underlying stock of a position will likely release an earnings report at some point each quarter. Depending on the outcome of the earnings, the price of an underlying stock may go significantly up or down. If a good earnings report is released, it is likely that the stock will appreciate in price. For a seller of a cash secured put, this will have very little effect. The buyer will likely choose to allow the option to expire with no further action taken, and the seller will profit because of the premium that they were paid for the option.
However, a bad earnings report may also be released, which could cause a drop in the price of the underlying stock. This could greatly increase the chances that the put will be exercised by the buyer and the seller will be compelled to purchase shares of the stock. The seller’s opinion on this outcome will be shaped by their opinion of owning the underlying stock. We will discuss this in more detail a bit later.
If a company is scheduled to release earnings before the expiration date, the options will have more volatility since this event is likely to have a large influence on the stock’s price, positive or negative. Greater volatility will increase option premiums, meaning more income for the cash secured put seller.
Dividends represent another tool that can be used to generate income. A seller may choose to sell a put against a particular stock with the idea that, if the stock is ultimately purchased, they will be able to start earning the dividend that the stock pays. Keep in mind, traders will not be paid a dividend by selling a cash secured put. An investor must own the share to receive a payment.
Dividend payments will also impact option prices. If the ex-dividend date is before the expiration date, the stock’s price will drop by the dividend amount all else being equal. This decline could cause the stock’s price to drop below the put strike price triggering a potential assignment.
Liquidity for options is primarily determined by two different metrics, volume and open interest. Volume refers to the number of trades made of the particular option during the current trading day. Open Interest, meanwhile, refers to the number of contracts that are currently active and have not yet been settled.
Liquidity is very important in determining how efficiently an option contract is priced. Higher open interest and volume should create a tighter spread between the bid and ask prices of the option. This means an investor can trade the options knowing they are receiving the best price. Thin volume and open interest can make entry and exiting an option trade costly. For the most part, investors don’t need to worry about the bid ask spread when trading stocks. But, that is not the case with options.
Good Stocks for Cash Secured Puts?
When trying to determine what specific stock to sell cash secured put options against, there are some questions that an investor should ask. Arguably, the primary question to answer is: Do I desire to actually own shares of the underlying stock if the buyer of the option chooses to exercise it?
If the answer is yes, the stock would make a great candidate for selling cash secured puts. By applying this strategy, the trader will be paid a premium by selling put options without owning any shares. When an investor is unsure which stocks they want to own, it is important to consider a company’s fundamentals and quality of earnings. Also, stocks that pay a dividend or which have overall good prospects for future growth (even if the price may have dropped somewhat in the short term) can make strong candidates for cash secured puts.
If the answer is no, selling a cash secured put option may not be the best strategy. Keep in mind, by selling a put the trader is obligating themselves to purchase shares if the stock’s market price drops below the option’s strike price. Option traders can “buy-to-close” the cash secured put to avoid an assignment. But, the cost to purchase the option can be higher than the premium received at the time of the original sale.
How to Screen for Cash Secured Puts
With all of the knowledge needed to sell a cash secured put, it can certainly seem a little daunting for an average investor. Fortunately, there are a number of screener sites available, which can allow the trader to search for cash secured puts that they might be interested in trading. The best screeners will offer a large number of criteria that investors can use to search for stocks to trade with, which we will discuss below.
Most investors tend to search for stocks to sell puts against in a specific price range. This is usually dictated by the amount of resources that the investor has available. A smaller account will have less cash to use to purchase shares of a position if the put is exercised; therefore a trader in this situation would want to search for positions in a lower range of prices. As the amount of cash in the account is increased, the trader can adjust the price range to search for stocks with a higher market value.
If an investor has investable cash of $6,000, they are only capable of selling a cash secured put option with a strike price of $60 or less. Don’t forget, each option contract consists of 100 shares of the underlying stock. In this scenario, the market price of the stock can’t be trading too much higher than $60 for the put contract to have value.
Bigger Account = More Choices
As the size of an investment account grows, the investor has more choices for their cash secured puts. With a large amount of cash, an investor can sell puts against a large number of different stocks. Or, they could sell fewer puts on stocks trading at a higher market price.
Using the “percent downside protection” measure available on most cash secured put screeners, a trader can compare the amount of premium received relative to the market price of the stock. A premium of $5 at the $100 strike price is the same as a $2.50 premium at a $50 strike price. Both stocks would return a percent downside protection of 5%.
Cash secured put screeners typically allow an investor to screen for puts via the expiration date for the option. As noted earlier, this can be for either the traditional monthly expiration date or for the newer daily or weekly expiration dates. Not all stocks will have daily or weekly expirations. They typically only exist on larger, more commonly traded stocks.
There are various advantages and disadvantages to both monthly, weekly, and daily expiring options. Equity options (like covered calls and cash secured puts) have a time value; all option sellers are basically selling the time between the option trade and expiration. This time value decays each day as expiration approaches. This decay increases the closer an option gets to the expiration date. As a result, selling options can be very profitable.
Due to time decay, it is best for option sellers to focus on the short-term, or options expiring within the next month. Considering key events like an earnings report or ex-dividend date is important when considering an expiration.
Finally, the frequency of trading is a major consideration. Applying a consistent strategy will create the best chances of success for an investor. Selling cash secured puts each week requires an investor to monitor their portfolio very closely. By choosing weekly or monthly option expiration dates, the time necessary to manage a portfolio is reduced.
Cash secured put screeners will also generally allow an investor to screen stocks via their fundamental economic metrics. This will generally include items such as earnings-per-share, price to earnings (PE) ratio, dividend yield, and the moving average price of the underlying stock over a specified period of time (i.e. 50 days, 100 days, etc.)
Some screeners may also allow investors to screen by the specific sector or industry that they are interested in trading in. For example, an investor that is interested in selling puts on energy or technology stocks can typically search within those sectors. Screeners may also allow a trader to screen only for exchange-traded funds (ETFs).
What Is The Best Options Strategy for Selling Put Options?
Let’s conclude our discussion by giving an overview of the best strategy for selling put options to generate income. In short, the best strategy for selling put options is the wheel strategy.
The following description is a brief summary; before embarking on any investment strategy, please take the time to perform thorough research to determine if the particular strategy is one that will be prudent for you to pursue according to your risk profile and investment objectives.
What is the Options Wheel Strategy?
The options wheel is one of the best, and more common strategies that many investors use to sell cash secured puts.
To start, an investor will use a screener to locate a stock (or stocks) that the investor believes will appreciate in value and which has an attractive premium. After locating a position, the investor will sell a cash secured put against the holding, at a strike price that they would feel comfortable purchasing the stock at if they ultimately are required to do so.
Fast Forward to Expiration
At the subsequent expiration date, the investor is generally hoping that the price of the stock will have either gone up or remain unchanged. This will result in the option expiring worthless by the buyer, thus relieving the seller of needing to purchase shares of the position and allowing them to keep the premium that was paid as profit. If this is indeed the case, the seller of the put can either choose to then sell another put on the same stock (if they believe that it will still appreciate in value) or can screen to find another stock that is attractive for pursuing the strategy.
Should the wheel strategy be practiced for a long enough period of time, it stands to reason that one of the cash secured puts that an investor sells will eventually be exercised by the buyer. And, if this does occur, the strategy would then shift. The seller, who now owns the stock, would begin selling covered call options at the same strike price that the put was exercised at. If the seller desires, they can also resume selling cash secured puts at a new, lower strike price, allowing them to earn two different premiums on the position.
Benefits of the Options Wheel Strategy
- Generate consistent income, particularly if the investor is selling on a frequent basis,
- Provide protection from extreme price volatility in the market,
- Allow for easier dollar cost averaging by allowing the seller to potentially purchase shares at different price points.
The options wheel strategy’s simplicity allows for it to be grasped relatively easily by a wide range of investors.
Options Wheel Strategy Drawbacks
There are, however, some drawbacks to the options wheel as well. It is generally ineffective for smaller accounts; the options wheel strategy is predicated on selling cash secured put options, and there is the possibility that a seller may be required to make several different purchases of the underlying stock while trading the options wheel. Smaller accounts will likely not have the resources to be able to make these purchases. The seller of an option could avoid this by buying back the open option; however, if the market price of the underlying stock has dropped, the price that the seller will have to pay to buy back the option will likely be much higher than the premium they received for selling it in the first place. This would result in a net loss on the trade.
The options wheel should also be avoided by traders who are totally averse to actually owning shares of the underlying stock. The strategy also limits the potential upside for the investor. If the put is not assigned, the only profit that the investor will receive is the premium for the option that was sold.
Overall, selling cash secured put options can be an excellent strategy for investors to utilize when looking to boost the income from their portfolio. Although less common than covered calls, they share the same risk profile as well as the profit-loss payout. Regardless of whether you sell cash secured puts or covered calls, both offer several advantages over riskier, high-leveraged option trades.