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Sell Cash Covered Puts and Buy Stocks at a Discount

Options are an amazing asset class that once understood create many possibilities to profit in the markets.  A lesser known options strategy is selling a Cash Covered Put as a way to buy stocks at a discount. 

The safest way to play this strategy is first, only on stocks you like and want to buy anyway.  The second (and very important) part is to only sell contracts equal to the cash in your account (never do this on margin).  This strategy has the same risk reward profile as covered calls.  Never use margin until you have more experience and a bigger trading account.  

Like covered calls, this strategy allows you to make money if the stock goes up, down a little bit, or sideways.  It is a non-directional strategy.

In this strategy, you sell a put which obligates you to buy the underlying at the strike price.  So let’s say you really want ABC stock at its current price of $48.  Instead of pulling the cash out of your account to buy ABC at $48, you sell a $45 put which obligates you to buy ABC stock at $45.  

Selling a put pays you a premium and you only buy ABC stock if it goes on sale down to $45. You can keep writing yourself a paycheck to buy ABC stock each week or month until you get “put” the stock at the sale price represented by the strike price.  

For those who focus only on generating cash flow, this is a great way to cash flow into a position.  Once you own the stock, keep writing yourself weekly or monthly paychecks by selling covered calls until the stock is called away.  Then repeat over and over again. 

Selling Puts to Generate Income

How would you like to get paid to purchase a stock you like?  Selling cash covered puts is a strategy where the market deposits money into your account over and over until you finally get “put” the stock you already wanted to buy.  It’s a great way to reduce your cost basis for that position before you even own it!

Selling a put option creates an obligation to buy the underlying at the strike price.  So the safest way to play this strategy is to only do it on stocks you like and wouldn’t mind owning.  So let’s say you’d like to get into ABC stock at its current price of $48.  You could choose to buy the stock on the open market and pay full price at that moment.  Or instead of taking money out of your account to buy the stock, you could leave that money in your account and sell a put covered by the cash sitting in your account.  

Now let’s say that ABC stock has weekly options with strike prices every $2.50.  You decide to sell the next week’s $47.50 strike price option for wholesale price of $1.04 (Bid price).  Because the safest way to employ this strategy is to have enough cash in your account to buy the stock at the strike price of $47.50 it’s important to know how much cash you need. 

In this this case, ABC options are the standard options which trade in lots of 100 shares per contract.  This means you need to have enough cash in your account to cover the total purchase obligation of $4,750 (100 shares x $47.50 per share strike price) per contract sold.  Let’s say you have enough cash in your account to do 10 contracts.  How much cash do you need?  You need $47,500 in cash to cover the obligation entered into by selling 10, $47.50 put contracts on ABC stock.  By entering into this position, you’ll get paid $1,040 ($1.04 bid price x 100 shares per contract x 10 contracts).  This represents a 2.1% weekly return (108% annualized) on a stock you don’t own yet!

What just happened?  You keep your $47,500 of cash in your account (safest not to use margin) and get paid $1,040 to obligate yourself to buy a stock you like (ABC) at a discounted price ($47.50 verses the current good price of $48).  You are under the obligation to buy this stock for just one week.  You generated a 108% annualized return on a stock you don’t own and are only willing to buy at a discount to its current price.  You get paid by the market to buy the stock you like…on your terms!

This strategy is often employed by corporations who institute stock buyback programs. The corporations use this strategy to reduce risk, create income, and provide bullish pressure on the stock. Selling a cash covered put makes it possible but does not guarantee you will acquire the equity at the strike price by expiration.  If you don’t end up with the stock at the discounted price, just keep selling puts (adjusting your strike price as needed) again and again and again….making money every time.

One thing to understand about this strategy is that you don’t own the stock.  This is a cash flow strategy.  If the stock rockets to the moon, you can keep getting your weekly/monthly paycheck, but you don’t get to participate in any appreciation in the underlying.  This is known as an opportunity risk.  But if you just focus on the cash flow, then missing out on this possible appreciation doesn’t really matter.  

This can be a great income strategy. If the buyer does exercise their right to put shares to you…great!  You wanted to own the stock anyway.  With this strategy you get the stock you want at the price you choose and get paid for the convenience.  This means you lower your cost basis in the stock before you even own it.

As we shared in other lessons, an option’s value boils down to two basic things:  Time value and intrinsic (in-the-money) value.  The most expensive Time value is always found in those options closest to the current price of the stock.  This means that the best put options to sell (for higher premiums) will be the ones closest to the “at-the-money” price.

Time value decays every day which works in the favor of option sellers.  During certain highly volatile periods when time value is expensive, it’s possible to sell an option and then buy it back before expiration (locking in a profit) only to sell another put option and get paid twice that week or month!  

This strategy should not be used unless you have the cash in your account to buy the shares at the strike price. You do not want to sell an option unless you have the means to perform under the terms of the obligation you sold.  So don’t sell puts on margin or don’t obligate yourself to buy more stock than you have cash in your account to cover unless you really know what you’re doing and you have a sizable trading account.  Using this strategy on margin means you could end up receiving a margin call. As long as you keep enough cash in your account to buy the shares, you avoid unnecessary risk.

Selling cash covered puts has the same obligation and provides the same reward, carries the same risk and has the same probability as a covered call.

Both of these strategies are non-directional.  This means the stock could move in your desired direction, stay the same or even move in the opposite direction a little bit and still be profitable.  Both strategies are cash flowing strategies where you give up the potential of unlimited appreciation in favor of limited (and more consistent) profits.

Both strategies are done on stocks trending up or at least trending flat.  You don’t want to own stock (or obligate yourself to buy stock) which is falling in price.  The biggest risk in both of these strategies is the stock going to zero.  The biggest opportunity risk in both of these strategies is missing out on the appreciation of a massive potential move the stock might make.

The main difference between the two strategies if a stock closes above its strike price on expiration is that the call sold will trigger and assignment of shares…or the shares will be called away.  While a cash covered put allows you to keep the premium and assignment does not happen. You are then free to sell another put and continue the income strategy.

On the other hand, if the stock closes below the strike price of a covered call, you keep the premium earned when you sold the call and you keep your shares. If this happens with a cash covered put strategy, you keep the premium and are assigned shares.  You can then sell calls covered by the stock in your account to keep up the income strategy.  

If you favor the income strategies, you can use cash covered puts to pay less commissions to enter a trade, and then switch to covered calls when the put is assigned. When the covered call is assigned, you can switch back to selling cash covered puts again to continue the income strategy.

Income strategies like covered calls and cash covered puts work very well with weekly options. Weekly options will pay you smaller paychecks, but the annualized income (and return) is much higher.

The other reason to sell cash covered puts is that put options tend to have the highest premiums. This is because of the portfolio hedging of big funds. They create a greater demand for put options, which according to the economic law of supply and demand, means higher prices for you.  Obviously higher prices means better return for you! 

Selling puts is a little known strategy for the average investor but it is a well-known and widely used way for more sophisticated investors to reduce risk and exposure in the markets by generating consistent profits.  Happy trading!  [/vc_column_text][/vc_column][/vc_row][vc_row][vc_column width=”1/1″][uncode_block id=”4146″][/vc_column][/vc_row]