Buying put options is fairly straightforward, but selling (or writing) options allows an investor to collect money upfront as an option premium, creating profitable trading opportunities when markets are neutral, bearish or bullish. However, writing options comes with a significant drawback: massive downside risk. Two of the more common put writing strategies are covered puts vs. cash-secured puts. While they may sound similar, both trades have drastically different risk profiles and outcomes for investors' portfolios.
What Are Covered Puts?
A covered put is a bearish options strategy where an investor seeks to profit from a short-term downturn in the price of a particular stock or ETF. But unlike a covered call, a safer and more bullish trade, covered puts can be risky since the underlying stock is sold short and not already owned in the investor’s account.
Losses could be unlimited when executing a covered put strategy, so understand how the trade works before attempting it. Covered puts are only profitable within a specific range of prices in the underlying asset. Short selling is only recommended for experienced investors who manage risk appropriately.
How Does a Covered Put Work?
Once the short position is established, you sell a put option on the same stock with a strike price below the purchase price of the short position. This creates a cash position in the account (short position + option premium). The goal is to close the short position at the option strike price, which is the maximum profit attainable.
When to Use Covered Puts?
A covered put strategy has limited profit opportunities. A short position alone would be more profitable than a covered put should the stock decline below the option strike price, so the ideal scenario for this trade is a moderate or range-bound decline in stock price.
Advantages of Covered Puts
A covered put creates a net credit in your account (cash from selling the stock short, plus premium from selling the option). You can use this cash in interest-accruing vehicles until the position needs to be closed. A covered put also allows investors to profit in range-bound markets.
Things to Consider with Covered Puts
Selling covered puts is risky because of the potential unlimited losses should the stock price rise rapidly. If the underlying stock doubles during the life of the trade, the investment will be down nearly 50% from the short position. Only the premium received from the put option will offset the losses from the short position. Assignment risk is also present in this trade, which could force the investor to buy shares before they want to in order to fulfill their obligation.
Example of Using Covered Puts
If you expect Company ZZZ shares to drop soon, you might short 100 shares of stock at $10 and then sell a short-dated put option with a strike price of $8. The breakeven point of this trade would be just above $10, depending on the premium received from the option. If the stock price drops to $8, you can close the short for a $2 gain per share and fulfill your put obligation should the option be exercised. Max profit here is the short price - strike price + option premium.
What’s the downside in this trade? If ZZZ rises rapidly, the short position will quickly find itself underwater. If the stock price rises too high, the premium received from selling the put option may fail to offset the losses from the short position.
What Are Cash-Secured Puts?
Cash-secured puts are another options strategy with a slightly bearish tilt meant for range-bound markets. However, they’re less risky than covered puts since no short position is established.
How Does a Cash-Secured Put Work?
A cash-secured put is when you sell a put option on a specific stock or ETF while having cash in your account to cover your obligation. To use a cash-secured put, you’d first need to fund your account with enough capital to purchase 100 shares of whatever stock you’re looking at and then sell a put option with a strike price lower than the current market price. The cash protects the position should the stock drop to the strike price, at which point you could buy the shares if assignment occurs.
When to Use Cash-Secured Put?
Neutral-to-bearish markets are best for these types of trades. Many traders execute a cash-secured put to buy shares at a lower price later on. If you expect a moderate decline in the price of a particular stock, a cash-secured put can be a way to take advantage of it.
Advantages of Cash-Secured Put
A cash-secured put doesn’t require short selling, so investors have less risk. If the stock reaches the option strike price, the writer has enough cash on hand to buy the shares at assignment. In fact, this is often the goal of a cash-secured put — getting shares at a lower value and then seeing an upswing commence. The option is worthless if the stock doesn’t reach the strike price, but the writer keeps the premium.
Things to Consider with Cash-Secured Put
If the stock goes to zero, you will be under obligation to buy it at the strike price anyway. Additionally, you’ll need to consider the opportunity costs of having cash on hand to secure the position, which you could use to earn higher profits in other securities.
Example of Using Cash-Secured Put
Let’s say Company ZZZ is trading at $75 per share. To use a cash-secured put, you’ll fund $7,500 to your account and then write a short-dated put option with a strike price below the current market price. For example, if the option has a $70 strike and assignment occurs, you’ll buy 100 shares for $7,000. If the option expires worthless, you won’t get discounted shares, but you can keep the premium.
Covered Puts vs. Cash-Secured Puts: Similar Contracts, Different Outcomes
While these two trades sound similar, they vary significantly regarding risk. A covered put requires short-selling, which could inflict vast losses on an unsuspecting investor. A cash-secured put doesn’t have many opportunities to amass profits, but it’s a safer trade and often used by investors who want to collect a premium now and buy cheaper shares later. Despite the differences, both covered puts and cash-secured puts are advanced strategies and should only by used by seasoned options traders.
Frequently Asked Questions
Are covered puts risky?
Yes, covered puts are risky because the trade involves short-selling a stock, potentially resulting in losses beyond the investor’s original capital infusion.
Are cash secured puts a good strategy?
Cash-secured puts can be a good investing strategy if you have a neutral or slightly bearish short-term outlook and want to earn income in the present while potentially waiting to buy cheaper shares in the future.
Is buying covered puts bullish?
No, a covered put is a bearish or market-neutral strategy designed to profit from a short-term decline in the underlying stock’s price. The investor will lose money on a covered put position if the stock price rises.
About Dan Schmidt
Dan Schmidt is a finance writer passionate about helping readers understand how assets and markets work. He has over six years of writing experience, focused on stocks. His work has been published by Vanguard, Capital One, PenFed Credit Union, MarketBeat, and Fora Financial. Dan lives in Bucks County, PA with his wife and enjoys summers at Citizens Bank Park cheering on the Phillies.