From the June 01, 2011 issue of Futures Magazine • Subscribe!

Selling cash-secured puts to generate income

Option Strategy

Question: How can you generate a return while waiting to enter the market?

Answer: Sell cash-secured puts.

If you are an investor sitting on a pile of cash waiting for the market to pull back, I don’t have to remind you how little interest you are earning these days. Selling puts against the cash in your account gives the potential to earn a nice return while waiting for the market to reach the entry price for a particular stock or other product. For example, suppose we like the infamous XYZ Inc, which is trading at $350. However, we don’t want to pay more than $325. In our trading account we have $100,000 and with XYZ trading at around $350, we are interested in purchasing 100 shares. Traditionally, we would enter a limit order and wait. However, by selling a put we not only get a better price if the stock drops down to $325, but we can earn some cash while we wait.

In this example, we could sell the 325 puts with 52 days until expiration for $3.60. The price for which we can sell the puts is a function of days until expiration, how far out of the money they are and the level of implied volatility. By selling the 325 put we are obligated to pay $325 anytime between now and expiration if we are assigned, which will occur if the stock drops below $325. The "cash-secured" portion of this transaction means we must commit enough cash to pay for the stock should we get assigned, in this case 100 shares times the price we will be paying for the stock ($325) or $32,500. The $360 we received ($3.60 x 100) by selling the put is ours to keep whether we get assigned or not, representing our return on our $32,500 cash commitment.

In this case we will generate a return of 1.03% over 52 days or an annualized return of 7.46% (not including brokerage commission).

Once we have sold our 325 put, if at expiration the stock is above $325, the put expires worthless and we simply keep our $360. If, however, the stock closes below $325, we will get assigned and be obligated to purchase 100 shares of XYZ stock at $325. Our effective cost, however, is not $325 but $321.40. The $3.60 we collected for the put lowers the cost basis. "Having your cake…" shows a parity graph of what the position would look like along a range of prices.

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Notice the break-even point (BEP) below the strike price, in this case $321.40. Also note the flat curve above the strike price representing the fixed $3.60 we collected and will keep as the option expires worthless.

There are essentially two risks we should be aware of when entering this trade. First, if the stock continues to rally and our puts expire worthless, we will have no position. Though we will collect our cash and a very nice return over a specific time period, if the stock price moves up dramatically, we will not be participating. Second, if the stock moves down dramatically, and we get assigned on our puts, our cost will be, in this case, $321.40. This will be the case even if the stock drops well below that price level. We must be prepared to own the stock at our effective cost even if the stock is trading much lower or buy back the put at a potentially much higher price and incur a realized loss.

The cash-secured put can be a valuable tool for the investor. It can serve to generate a return on cash in our brokerage account or purchase shares of stock at a predetermined price point, often well below the current market. Puts that do go deep in the money prior to expiration can be assigned to the investor prior to expiration, so it would be prudent to be aware of that possibility and when it might occur. Before placing cash-secured put trades, especially in retirement accounts, you always should check with your broker regarding rules for doing so.

Steve Papale is an options analyst with KnowYourOptionsInc. From 1987 to 1999, Steve was a market maker at the CBOE and CME where he focused on trading stock indices, currency options and equity options.

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