Options trading can seem intimidating at first, but it offers strategies that can enhance returns, hedge risk, or generate additional income. Among the more popular strategies for investors looking to generate passive income are cash-secured puts and covered calls. In this blog post, we’ll explain both of these strategies in simple terms, highlight their benefits and risks, and help you decide if they’re suitable for your investing goals.
What is a Cash-Secured Put?
A cash-secured put is an options strategy where an investor sells a put option while holding enough cash in their account to buy the underlying stock if the option is exercised. This strategy is typically used when the investor believes the price of the stock will not fall below a certain level and they are willing to buy the stock at that price.
How Cash-Secured Puts Work:
Sell a Put Option: You sell a put option contract, which gives the buyer the right (but not the obligation) to sell a stock to you at a predetermined price (the strike price) before the option expires.
Secure the Put with Cash: To execute the strategy, you need to have enough cash in your account to buy the stock at the strike price, in case the option is exercised. For example, if you sell a put on 100 shares of stock at a $50 strike price, you need to have $5,000 in cash in your account to cover the potential purchase.
Receive a Premium: In exchange for selling the put option, you collect a premium from the buyer. This premium is yours to keep, regardless of whether the option is exercised.
What Happens Next?
- If the stock price stays above the strike price: The option will expire worthless, and you keep the premium as profit. In this case, you don’t have to buy the stock.
- If the stock price falls below the strike price: The buyer may exercise the option, and you’ll be required to purchase the stock at the strike price. However, your effective cost basis will be lower than the strike price because you already received the premium from selling the put.
Example of a Cash-Secured Put:
Let’s say you sell a cash-secured put on 100 shares of XYZ Company with a strike price of $50, expiring in 30 days. The premium you collect for selling the put is $2 per share, or $200 in total.
- If XYZ’s stock stays above $50, the option expires worthless, and you keep the $200 premium as profit.
- If XYZ’s stock drops below $50, you may be forced to buy the stock at $50 per share, but your effective cost basis would be $48 per share ($50 strike price minus the $2 premium you received).
What is a Covered Call?
A covered call is another popular options strategy that involves holding a long position in a stock and selling a call option on the same stock. This strategy is generally used by investors who want to generate additional income from stocks they already own, particularly when they believe the stock price will remain relatively stable or rise only modestly.
How Covered Calls Work:
Own the Underlying Stock: First, you need to own the stock or shares that you want to write a call option on. The number of shares you own will determine the number of contracts you can sell. One options contract typically represents 100 shares of stock.
Sell a Call Option: You sell a call option contract, which gives the buyer the right (but not the obligation) to buy the stock from you at a predetermined price (the strike price) before the option expires.
Collect the Premium: Just like in the cash-secured put strategy, you receive a premium for selling the call option. This premium is yours to keep, regardless of whether the option is exercised.
What Happens Next?
- If the stock price stays below the strike price: The call option will expire worthless, and you keep both the stock and the premium. This allows you to generate additional income from your stock holdings.
- If the stock price rises above the strike price: The buyer may exercise the call option, and you’ll be required to sell your stock at the strike price. In this case, you still keep the premium, but you may miss out on any gains above the strike price.
Example of a Covered Call:
Let’s say you own 100 shares of ABC Company, currently trading at $60 per share. You decide to sell a call option with a strike price of $65, expiring in 30 days. You collect a premium of $3 per share, or $300 in total.
- If ABC’s stock stays below $65, the call option expires worthless, and you keep both your shares and the $300 premium.
- If ABC’s stock rises above $65, the buyer may exercise the option, and you will be required to sell your shares at $65 per share. However, you still keep the $300 premium and any capital gains up to the $65 strike price.
Benefits and Risks of Cash-Secured Puts and Covered Calls
Benefits:
- Income Generation: Both strategies allow investors to earn income from premiums, which can be particularly appealing in a flat or mildly bullish market.
- Downside Protection (Cash-Secured Puts): With a cash-secured put, you’re willing to buy the stock at a lower price (the strike price), which could be advantageous if you are interested in the stock at that price.
- Enhanced Returns (Covered Calls): By selling a call, you enhance your return on stock holdings by generating premium income, especially if the stock price remains flat or rises slowly.
Risks:
- Limited Upside (Covered Calls): The main risk with covered calls is that if the stock price rises significantly above the strike price, you may miss out on those gains since you’ll be obligated to sell the stock at the strike price.
- Potential for Losses (Cash-Secured Puts): If the stock price falls significantly below the strike price, you may be forced to buy the stock at a much higher price than its market value, which could lead to losses.
- Obligation to Buy or Sell: Both strategies come with the obligation to buy (in the case of cash-secured puts) or sell (in the case of covered calls) the stock if the options are exercised.
Final Thoughts
Cash-secured puts and covered calls are excellent strategies for investors seeking additional income and willing to take on certain risks. Cash-secured puts are ideal if you’re interested in buying stocks at a lower price and can afford to hold them if the price declines, while covered calls are better suited for those who already own stocks and want to generate additional income without giving up too much upside potential.
Before incorporating these strategies into your portfolio, it’s important to understand the risks and rewards, and how they fit with your investment objectives. Options can be complex, so consulting with a financial advisor or doing thorough research is highly recommended.
Both strategies can be powerful tools for enhancing your returns and managing your investments, but only if you fully understand how they work and the potential risks involved.
