Do you like buying car insurance? Chances are, you don’t. Every year, we pay the insurance premium but rarely (hopefully never) have to use it. 

If you have some experience with trading options, you’ve probably experienced something similar. You buy an option, but it expires and you never get to exercise it. Hopefully, that was a protective put — then at least you’ve got your long stock position. And if it was a speculative bet, that’s a 100% loss. The options seller, however, has pocketed your options premium. Just like your car insurer. 

The good news is that in the stock market you can be the insurer. That’s known as writing puts. 

In this article, we’ll review cash-secured puts, one of the more advanced options trading strategies that can generate a stable cash flow or lower your costs for stocks, boosting your total return. 

How Put Option Works

Writing puts is an advanced options strategy, so this article will be filled with lots of jargon. (Here’s a quick refresher on options trading basics if you need it). 

OK, now we’re ready to dive straight in. 

In any options trade, there are two sides: an options seller (also known as the options writer) and an options buyer (also known as the options holder).

A put option gives its holder a right but not an obligation to sell 100 shares of stock or ETF at a strike price by the expiration date. For the options seller, the put option is an obligation to buy the shares at the strike price if the option is exercised.

Pay-Off for Put Options Buyer

The put options buyer hopes for the stock price to go down: They would buy the shares at the lower price in the market and immediately sell at the strike price, which would be higher than the current market price. To breakeven and make a profit, the difference between the two prices should be higher than the premium paid to buy the option. This trade is also known as a long put. 

• Maximum profit: The potential profit is equal to 100 shares of stock multiplied by the strike price. For the put option holder, the ideal situation would be for the company to go bankrupt. The share would hit zero and would yield a hefty profit from selling the shares at the strike price to the unlucky options writer. 
• Maximum loss: The maximum loss is the option premium paid to the option seller (you).  

Pay-Off for Put Options Seller

As an options writer, you issue a put option and collect an option premium from the buyer. This is also known as a short put.

If the stock price hasn’t declined to the strike price by the expiration date, the option expires worthless (out of the money), and you don’t have to do anything. You’ve already pocketed your profit when you sold the option.

Conversely, if the stock price goes below the strike price, the options holder exercises their in-the-money put and you must buy their shares. 

• Maximum profit: The potential profit is the option premium that the options buyer pays you.
• Maximum loss: The maximum loss is the 100 shares of stock multiplied by the strike price. In the (unlikely) worst-case scenario, the shares would go to zero, and you’ll still need to buy them at the strike price.  

At first look, this might appear to be a low-reward, high-risk strategy. For most stocks, however, bankruptcy is very unlikely. And for an ETF that tracks the S&P 500 or other major stock market index, it’s virtually impossible for the price to go to zero. 

Soon, we’ll see that the reward isn’t as low as it might seem. 

Cash-Secured Puts: Get Income or Buy the Stock Cheap

As we’ve seen, writing options is risky. So your brokerage will likely not let you do that without making sure that you have the assets to meet the obligation if the option is exercised.

As an option writer, you’ll need to either have: 

• A long stock position that you can close and deliver the stock if you’re writing a call
• Enough cash to cover the position to buy 100 shares of stock if you’re writing a put

As you can see, writing puts is more flexible than writing covered calls. If you have enough cash, you can write puts for any type of asset with any strike price or expiration date.

There are two main reasons why you might want to use short put strategies: to generate income or to buy the underlying stock at a lower price. 

Writing Puts for Income 

If you are bullish or neutral about some stocks or the whole market, you can write cash-secured puts and get some portfolio income.

Unlike with buying options, the time decay is on your side. As the expiration date approaches, the value and the price of the option declines. That’s good for you, because if the stock price stays the same or rises, you can buy back the option and close your trade before expiration.  

On the other hand, you want implied volatility to go down. Remember, options become more valuable if price volatility increases. So as an option seller, you don’t want the stock price to move too much — ideally, it should remain perfectly stable. 

Let’s use an example. 

Let’s imagine you’re pretty certain that, in the next six months, the S&P 500 won’t go below $3,380 (-20%), given the Fed’s plans to provide “powerful support” until the economy completely recovers. 

In that case, you can write a put option for SPY (NYSE:SPY), an ETF that tracks 1/10 of the cash value of the S&P 500. 

The strike price would be $338 (1/10th of $3,380), and the expiration date would be six months from today. Let’s say the latest price for a put option like that was $5.21.

If you’re right and the option expires worthless, your return is the premium you received divided by the cash position you’ve kept to cover it: $5.21 x 100 shares / $338 x 100 = 1.5%, or about 3% annualized (since the option was for six months). That’s much better than a savings account or other safe investments. 

Of course, if you’re wrong, you’ll have to buy 100 shares of SPY. That’s also the total cash you should set aside: $338 x 100 = $33,800. If you wouldn’t mind buying SPY at that price, that’s probably not the end of the world. 

Best market conditions for this strategy: Neutral to bullish in the near term. You’d want the stock price to remain the same or go up by the option’s expiration date.  

Writing Puts to Buy Stock at a Lower Cost 

Suppose there is a stock you’d like to hold for the long term but think the current market price is too high. In that case, you can simply create a limit order to buy at your desired stock price if there’s a correction. 

Or you can write a put option with your desired stock price as the strike price.

If you’re right, the options premium received will lower your cost basis for the stock position. 

And if you’re wrong and the option expires worthless, you won’t buy the stock, but at least you would keep the premium.  

Let’s look at an example. 

Perhaps you want to build a long stock position in Facebook (NASDAQ:FB) but consider the current price of $335 to be too high. You think it would be a good deal at $315, or 6% below the current market price. 

The latest price paid for an option with a strike price of $315 and an expiration date a month out is $5.75. You write a put option with these parameters and pocket the $575 premium ($5.75 x 100 shares). 

The expiration date arrives, the stock price is just below the strike price, and you get assigned 100 shares. Your total cost is the strike minus the premium: $315 – $5.75 = $309.40. 

So as long as the current market price is above that number, your option trade helped you to get a better cost.   

And if you’re wrong and FB continued to climb, you’d still keep your full cash position and that $575 in premium. (Yes, you’re paid for being wrong). 

Appropriate market conditions for this strategy: Bearish in the near term and bullish in the long term. If you want to buy the stock at a lower price, you’d want it to go down to your strike price.

Boost Your Returns With Options

We’ve looked at what cash-secured put strategies are and how you can use them to generate income or buy stocks at lower costs. You can use this strategy in practically any market condition: bearish, neutral, or bullish. 

Over the past year, the options market went through record growth in terms of volumes and new entrants. This created lots of great setups, not only for covered puts but also for other advanced options trading strategies. Some of them require just spare cash you can find around your house. If you want to learn how to find these trades, sign up for Investors Alley’s Options Floor Trader PRO.