Covered Puts vs. Cash Secured Puts: Which Is Better?

Covered puts involve holding a short position in a stock while also holding the corresponding number of shares, whereas cash secured puts involve selling put options backed by enough cash to purchase the stock if the option is exercised.

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. 

Why Should You Use Covered Puts?

Investing involves various strategies to manage risk and improve returns. One effective strategy is using covered puts. This method allows investors to generate income while protecting against losses. By selling put options on stocks they want to buy, investors earn premiums. These premiums provide a cushion against market ups and downs. If the options are exercised, the investor can buy shares at a lower price. As the market changes, understanding covered puts is important for optimizing investment strategies.

Income Generation

Selling a covered put helps you earn premium income upfront. This strategy provides consistent cash flow, especially if the put option expires unexercised. The premium received is an immediate profit. It can improve your overall return, even if the stock price does not drop below the strike price. For investors looking for steady income, covered puts are an effective way to monetize stocks they are willing to buy.

Purchase Stock at a Discount

When you use a covered put, you commit to buying the stock if its price falls to or below the strike price, while keeping the premium you received. This approach reduces your effective purchase price for the stock, often leading to a more favorable outcome than buying at the current market price. It's a strategy that value investors employ to acquire shares at a lower price while being compensated for the commitment they make.

Hedge Against Declines

Selling covered puts can act as a safeguard in a declining or unpredictable market. If you currently own shares or plan to purchase them later, selling a covered put provides some protection against downside risks. The premium received can help mitigate potential losses if the stock price decreases, allowing for a strategic approach to risk management while also preparing for future stock ownership at a more favorable price.

Considerations Before Using Covered Puts

Before exploring covered puts, it’s important to understand key factors. Covered puts involve selling put options while owning the underlying asset. This can boost returns and offer some protection against losses. However, there are risks involved that investors need to consider. Market volatility, risk tolerance, and investment goals are crucial in deciding if covered puts are right for you. Knowing how options trading works and when covered puts may be useful or harmful is also key. The following headings will break down these factors to help investors make informed decisions about covered puts.

Risk of Assignment

When you sell a covered put, you agree to buy the underlying stock if its price drops below the strike price by the expiration date. This strategy can be beneficial if you are okay with owning the stock at that price. However, it is essential to be financially ready to make the purchase if assigned. Ensure you have enough capital or margin to cover the full cost of the shares. Not preparing for this could lead to financial strain or forced selling in unfavorable conditions.

Limited Upside Potential

A covered put provides premium income. However, it limits your profit to just that amount. If the stock price rises significantly, you will not benefit from those gains. This strategy is ideal for investors who are neutral to slightly bearish on the stock. By using a covered put, you give up potential upside beyond the premium. If the stock rallies, you will miss out on price appreciation. You could have gained more by holding the stock or using other options strategies, such as selling covered calls.

Market Volatility

Covered puts generally perform well in stable or slightly declining markets. High volatility increases the risk of the stock price dropping below the strike price. This can lead to assignments. If the stock price falls sharply, you may end up purchasing shares at a much higher price than their current market value. This situation can result in unrealized losses. It is crucial to assess current market conditions and volatility levels before selling covered puts. Extreme fluctuations can decrease the effectiveness of this strategy.

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.

Why Should You Use Cash Secured Puts?

Cash secured puts are an investment strategy that can offer flexibility and potential income. Investors sell puts against cash reserves set aside for buying the underlying stock. This allows them to earn premium income and establish a set price for purchasing shares. This strategy can be beneficial in volatile or bearish markets. It provides the chance to buy stocks at lower prices while receiving income from the option premium. Cash secured puts promote discipline in investing and helps keep investors focused on their goals. They also provide a cushion against possible losses. Overall, cash secured puts can be a useful addition to your investment strategy.

Generate Income

Selling a cash-secured put generates immediate premium income, offering a dependable source of cash flow as you wait to purchase a stock at your preferred price. This approach enables you to earn money right away, regardless of whether the option is exercised. For investors looking for consistent income while remaining patient in establishing a stock position, cash-secured puts serve as a useful method to collect premiums and enhance returns, particularly in stable or slightly declining markets.

Acquire Stock at a Lower Price

Using cash-secured puts offers a chance to buy stock at a lower price than its current market value. If the option is exercised, you will need to buy the stock at the strike price. This price is often lower than the market price when the put was sold. This allows you to acquire shares at a discount. You also keep the premium you received from selling the put. For value investors, this method provides a strategic way to buy stocks under favorable conditions while being compensated for the obligation taken on.

Controlled Risk

Cash-secured puts provide a conservative approach to entering a stock position. This strategy requires that your obligation is fully backed by cash or equivalents. As a result, your risk is limited to the amount you have set aside to purchase the stock. Unlike other options strategies that use leverage, a cash-secured put caps your potential loss. This makes it appealing for risk-averse investors. They can manage risk while aiming for specific entry points in their investments.

Considerations Before Using Cash Secured Puts

Before starting a cash-secured put strategy, investors need to think about important factors that affect their financial outcomes. This strategy involves selling put options and setting aside enough cash to buy the underlying stock if needed. It can generate income from premiums and may allow for buying stock at a discount. However, it also has risks and requires a good understanding of the market. Key factors include market volatility, choosing the right stocks, and personal financial goals. Investors should also consider how their cash allocation affects other investment opportunities. By evaluating these factors, they can decide if this strategy fits their investment goals and risk tolerance.

Capital Requirement

Cash-secured puts require you to set aside enough cash to buy the underlying stock if the option is exercised. This means your committed cash will be tied up until the option either expired or is exercised. As a result, your flexibility to allocate that capital to other investments is limited. If you are assigned, the cash will be used to purchase the stock. This could prevent you from pursuing other potential investment opportunities at that time. It is important to consider how this might affect your overall investment portfolio and liquidity.

Limited Profit Potential

The maximum profit from a cash-secured put strategy is limited to the premium you earn when you sell the option, no matter how high the stock price might go. In contrast to directly owning the stock, which offers unlimited profit potential, a cash-secured put provides only the premium received without benefiting from substantial increases in the stock price. This strategy can be suitable for investors looking to generate income from the premium, but may not be the best choice for those anticipating a stock rally who wish to take advantage of that growth.

Market Conditions

Cash-secured puts work best in neutral or slightly bearish markets. In these conditions, the risk of a significant price decline is lower. If the stock price drops significantly below the strike price, you may end up buying shares at a higher price than their current market value. This situation can lead to unrealized losses. Consider this carefully in volatile or sharply declining markets, as the likelihood of assignment increases. Before selling a cash-secured put, assess the market conditions. Evaluate the stock's potential downside and your willingness to own the shares at the strike price.

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