Cash Secured Put Option Strategy

A cash secured put option strategy involves selling a put option while simultaneously setting aside cash as collateral. The objective of this strategy is typically to generate income from the premiums received for selling the put, while also being prepared to purchase the underlying stock if the option is exercised. The term "cash secured" means that the investor holds enough cash to buy the stock at the strike price if the put is assigned. This strategy is generally used by investors who have a neutral to bullish outlook on a stock, expecting it to stay above a certain price level.

In this strategy, the investor sells a put option, which gives the buyer the right to sell the stock at the strike price. If the stock price falls below the strike price at expiration, the investor may be required to buy the stock at that price, even if it is lower than the market value. This can result in potential losses, but the premium collected from selling the put offers some downside protection.

Example Scenario

Suppose an investor anticipates that the stock of EIO, currently trading at $8 per share, will remain above $8 for the foreseeable future. The investor decides to sell a put option with a strike price of $8, expiring in three months, and receives a $3 premium for the option. To secure the put, the investor is required to set aside $800 in cash as collateral to cover the potential obligation of buying 100 shares at $8 if the option is exercised.

  • Sell 1 EIO put option at the $8 strike price with 3 months until expiration for a premium of $3

  • Long $800 of cash as collateral

Profit and Loss Analysis

Maximum Profit: The maximum profit is the premium collected for selling the put option, which is $300. This is calculated as follows:

Maximum Profit per Option = Premium x 100 shares
Maximum Profit = $3 x 100 = $300

Maximum Loss: The maximum loss occurs if the stock price falls to zero. In this case, the investor would be required to purchase the stock at the strike price of $8, resulting in a loss of $500. This is calculated as follows:

Maximum Loss per Option = (Stock Purchase Price - Premium) x 100 shares
Maximum Loss = ($8 - $3) x 100 = $500

Breakeven Point: The breakeven point occurs when the stock price falls to the strike price minus the premium received. This is calculated as follows:

Breakeven Price = Short Put Strike Price - Premium
Breakeven Price = $8 - $3 = $5

Outcome Scenarios

  1. Stock Price Above $8 at Expiration: If the stock price remains above $8 at expiration, the put option expires worthless, and the investor keeps the full premium of $300.

  2. Stock Price Between $5 and $8 at Expiration: If the stock price falls between $5 and $8, the investor may be assigned and be obligated to purchase the stock at $8. In this case, the investor will have paid $8 per share but will have received $3 in premium, which provides a partial cushion for the loss. The net cost of acquiring the stock is effectively reduced to $5 per share, and the investor’s potential loss is limited to $500.

  3. Stock Price Below $5 at Expiration: If the stock price falls below $5, the investor will still be obligated to buy the stock at $8, and their unrealized loss will be larger. The total loss will be $500, as the stock is worth significantly less than the purchase price, though the $300 premium helps offset part of the downside.

Key Considerations

The cash secured put strategy is ideal for investors who have a neutral to bullish view on a stock and are willing to purchase the stock at the strike price if the option is exercised. While the premium collected offers income, the investor faces the risk of having to buy the stock at a higher price than its current market value if the stock declines. This strategy requires a moderate level of risk tolerance, as the investor is exposed to the full downside risk of the stock price falling significantly. However, the premium received can provide some downside protection and improve the overall return on the investment.

By carefully selecting the strike price and expiration date, investors can align the cash secured put strategy with their market outlook and risk preferences.