Cash-Secured Puts: The Step-By-Step Guide

|
Includes: DE, KO
by: Sure Dividend

This post was written by Eli Inkrot for Sure Dividend

In a previous article I provided a "step-by-step" guide for learning more about selling covered calls.

If you haven't yet read that piece I'd recommending taking a moment to do so. In either event I'll provide a quick refresher. It can be helpful to have this background in mind because a cash-secured put shares many of the same characteristics as the covered call.

Selling a covered call means that you own a security (in increments of 100 shares) and then make an agreement to sell your shares at a certain price in the future. For instance if you owned 100 shares of Coca-Cola (NYSE:KO) at a price of $45, you could sell a January 20th 2017 call option with a strike price of say $50. This means that you're willing to sell 100 shares of Coca-Cola at a price of $50 anytime between now and the next 10 months.

The benefit of making this agreement is that you receive an upfront premium. You can moderately or significantly increase your cash flow instead of solely relying on dividend income.

The downside is that if the share price rises dramatically, you could spend extra time and effort only to "cap" your eventual gains.

It's important to be content with either side of the agreement. You want to be happy whether or not the option happens to be exercised. This sounds simple enough, but it takes a bit of thought before you make the agreement.

The same basic notion applies to selling a cash-secured put; you want to be content with either side of the agreement.

The advantages and disadvantages are very similar. With that in mind, let's work through the basics of a cash-secured put.

Click to enlarge

What Is A Cash-Secured Put?

That's a good place to start. A put option gives the buyer the right, but not the obligation, to sell 100 shares of a company at a given price in the future.

Click to enlarge

Source: Option Monster

Let's say that someone holds 100 shares of Coca-Cola and they're worried that shares may go much lower for whatever reason.

This person could buy a put option with a strike price of say $40. This now gives the buyer the right to sell at $40 per share anytime between now and the expiration date.

If the share price remains above $40, the put option will expire worthless. (Why exercise your right to sell at $40, if you can sell on the market for say $45?) Instead of exercising the option, the buyer would allow the option to expire and instead sell shares in the open market if they wanted to do so. In this scenario the put option is said to be "out of the money".

Alternatively, if Coca-Cola's share price goes below $40, the put option is now said to be "in the money". In this case, the put option is valuable because it gives the buyer the right to sell at $40 when shares may be trading in the market at say $35.

Buying A Put Option Can Be Either Cautious or Speculative

If you own shares in a company and buy a put option, it's effectively like buying insurance on your shares -- no different than buying house insurance, as an example.

If the share price remains above your strike price, the option expires worthless. Alternatively, if the share price goes below the strike price you have now "capped" your downside. While the value of your shares would be declining, the value of your put option would be increasing.

Buying put options can be speculative if you do so without owning the underlying security. In this case it's sort of like buying house insurance on a neighbor's house. You would be betting on the share price to go down (or the house to get damaged). If the share price stays the same or goes up, your put option is worthless. If the share price goes down, the put option can become more valuable.

Buying put options can be either cautious or speculative. Put options are an "all or nothing" situation. Either the option is worthless or it pays out. For speculation this makes returns quite volatile. For "insurance" purposes, it can eat into the income you receive from a security but it may pay out later on.

That's on the buying side…

What I'd like to talk about for the remainder of this article is selling a cash-secured put.

The reason that it's called "cash-secured" is because you set aside the cash needed to buy shares to begin. So if you sold a put option with a $40 strike price, you would need to set aside $4,000 in order to make that agreement.

The put seller is on the opposite end of the transaction. I don't want to take this analogy too far because there's some important differences, but it's sort of like you're the insurance company. Selling a put option is making an agreement to buy 100 shares of security at a given price.

We'll continue with Coca-Cola before providing a real world example with a different company.

Let's say that you sell a put option on Coca-Cola with a $40 strike price. In this case you need to set aside $4,000 to buy 100 shares anytime between now and the option's expiration date. If the share price remains above $40, the option would not be exercised and your $4,000 would be "released" - free to be allocated again as you see fit. If the share price goes to $40 or below, the option will be exercised and you'll trade that $4,000 for 100 shares of Coca-Cola.

Now, why would anyone make this agreement?

Great question, I'm glad you asked. There are two basic reasons.

The first is that you get paid for doing so. The upfront cash flow is known as an option premium (which may be taxed at different rates than long-term capital gains, depending upon a few factors).

The second reason is that you're happy to own shares, but you'd rather do so at a lower cost basis. Selling a put option allows you to get paid for expressing this sentiment. Maybe your art teacher was right: it pays to express yourself.

Click to enlarge

An alternative to selling a put option is setting a limit order to buy 100 shares of Coca-Cola at a price of $40 per share. This has the same basic goal -- owning shares of Coca-Cola at $40 a share -- but you don't get paid for doing it this way.

Note: There is one advantage of the limit order, which I'll detail later on, but that's the simple reason for why someone might consider selling put options instead of setting up limit orders.

A Current Example Of A Cash-Secured Put

Coca-Cola works well as a demonstration, but I like to use a few securities to really outline the process. For this "real life" example of how you might think about selling a cash-secured put we'll use Deere & Co. (NYSE:DE).

Although the company operates in the agriculture, turf, construction, forestry and financial segments, you probably know the company best for its John Deere tractor.

Click to enlarge

Source: Deere Investor Relations

Deere traces its roots back to 1837 and has been a profitable powerhouse for many years since. Of course profitable isn't quite the same thing as consistent. There's a bit of cyclicality in the business.

From 2005 through 2014, Deere put together a rather solid record. The company grew revenues by 6% per year and company-wide earnings by 9% annually due to an expanding profit margin.

The per share metrics were even better. Earnings-per-share grew by almost 13% annually, while the share price and dividend per share grew by 12% and 15% respectively. Collectively, a Deere investor would have seen a $10,000 starting investment turn into $32,000 over the nine-year period.

Of course during this time you would have had to watch earnings-per-share drop 40% and the share price decrease 70% over the course of the most recent recession.

No matter how seasoned an investor you might be, this is the sort of situation that will test you. So it's important to be cognizant of the higher cyclicality associated with a company like Deere. Although the brand power is very real, the industry does not create the "steady eddy" nature of something like Dividend King Johnson & Johnson (NYSE:JNJ).

For those that can deal with the cyclicality -- which happens to be on the downdraft at present -- there are real rewards to be had. The company itself puts out a "why invest" section on its website.

Here's the basic idea: the world's population and especially the middle class will continue to grow. As such, grain-based diets and demand for farm commodities will keep increasing. On the other end of the spectrum, the world's population is becoming increasingly urbanized.

These factors could aid Deere's business is a couple of ways. First, you have more farm production needed with less rural labor to do so. Enter the John Deere tractor. Moreover, urbanization requires more infrastructure -- buildings, roads, housing, bridges, etc. This too is something that Deere can help out with.

Deere & Company's historical growth rate and future growth prospects are impressive. This combined with the company's above-average dividend yield of 3.0% makes Deere & Company a favorite of The 8 Rules of Dividend Investing.

So to continue with the example, let's suppose that you'd like to own shares in Deere & Co. You have a few alternatives:

  1. You could buy shares outright
  2. You could set up a limit order
  3. You could sell a cash-secured put

The last alternative (sell a cash-secured put) involves getting paid to make an agreement. We'll explore that route.

Let's See What Put Option Contracts Are Available

Most online brokerages will have information about the available options, but of course not everyone uses the same platform. As such, using a public resource like Yahoo Finance works well for demonstration purposes.

I'll walk you through the steps to get the information that you need. Once you type in "DE" for the ticker on Yahoo Finance, the site will provide you with a summary for the security. The third choice down is "options."

Click to enlarge

Once you select "options" you will be taken to the option page for Deere & Co. The default setting will be the closest expiration date. You can change this by using the drop down menu below the company name.

Click to enlarge

Here I have selected the January 20th, 2017 expiration date. Note that I have no affinity for this date, but it makes comparisons a bit easier.

The first table gives you information on the various call options that are available, as we covered in the previous step-by-step guide. The second table shows you what put options are available with the strike price, contract name, last price, bid and ask.

Click to enlarge

Now we're ready to think about a price at which we'd be happy to own shares of Deere. The last couple of times that shares have traded with a 3%+ dividend yield, it's worked out quite well for investors. This is certainly not to suggest that this must happen again in the future, but this could be a benchmark that you happen to use.

The current quarterly dividend sits at $0.60, or $2.40 on an annual basis. Based on this payout the "current" dividend yield sits right at 3%. Let's suppose that you'd be happy to own shares at a price of $75, representing a 3.2% yield should this transaction occur.

Here's what that strike price (with the January 20th, 2017 expiration date) looks like:

Click to enlarge

The current bid for the $75 strike price is $5.35; let's call it $5.25 to account for fees. This means that if you set aside $7,500 to buy 100 shares of Deere & Co. between now and January 17th of next year, you would receive ~$525 upfront for making that agreement.

A Look At The Outcomes

There are two basic things that could happen once you make that agreement:

  • The option is exercised
  • The option is not exercised

If the share price of Deere & Co. remains above $75, it's very unlikely that the put would be exercised (Why sell to you at $75, when the option buyer could sell for higher price on the market?).

In this scenario, the option expires worthless. You keep your $525 option premium and your $7,500 is "released" or available once again to be deployed as you see fit.

The upside in this scenario is that you received an immediate 7% yield based on the cash you set aside. The negative bit is that you don't yet have shares in a company that you'd like to own.

If the share price of Deere & Co. goes below $75, it's likely that the put would be exercised. In this case you would trade your $7,500 for 100 shares of Deere. You still keep your option premium of $525, but your total return would be based on what happens with the share price.

The upside is that you got to buy shares at a lower price. Better yet, you got paid for doing so, so your cost basis would now be below $70. The downside is that your return could still be negative (say if shares went to $65).

Yet I would contend that this isn't especially troublesome. If you were planning on buying shares anyway, selling the put option simply allowed you to do so at a lower price.

Let's summarize the information with the basic benefits and potential downsides of using a cash-secured puts. We'll start with the good stuff.

Put Option Benefit #1 = You Get Paid

Unlike a limit order, with selling puts you get paid to express your sentiment. Depending on the security and the price at which you're willing to buy, this cash flow can be significant. In the above scenario, if you agreed to buy shares of Deere & Co. at a 6% lower price you could collect a 7% yield in under 10 months.

Put Option Benefit #2 = You Can Reinvest Right Away

Not only can the cash flow be significant, but it also happens immediately. You make an agreement now and a few seconds later that capital is available to you to be deployed. There's a time value of money aspect here that can make option income more attractive than waiting on other sources of cash flow.

Put Option Benefit #3 = You're Able To Dictate A Lower Price

I used a price of $75 in the above example, but it follows that there are hundreds of available strike prices and expiration dates. If you feel that $50 would be a great price, you can make that agreement and still get paid for doing so. Granted the option premium is going to be lower in this scenario, so it's paramount to think about the opportunity costs of having to set aside those funds. Still, using a put option can give you great flexibility in that you're not simply taking what the market happens to offering.

Put Option Benefit #4 = Allows You To Own Lower Yielding Securities

You might think that say Visa (NYSE:V) is an excellent company, but have never really given it much attention due to its low dividend yield. By selling a cash-secured put you could get paid for agreeing to a lower price and thus increase your cash flow stream. Options are aptly named. They can open up possibilities that you may not have previously considered.

That does it for the positives, now let's move on to some potential downsides.

Put Option Downside #1 = You Have To Work In Round Lots

Options trade in "round lots" of 100 shares. So if you have say $5,500 to deploy you couldn't use the cash-secured put option for Deere that was described above.

Usually share price does not matter (in dollar terms, not in value terms), but in this situation it certainly does. This requirement can limit the feasibility of allocating capital in this manner.

Put Option Downside #2 = You May Never Own Shares

If the share price stays higher, you may never own shares. Even if the price momentarily moves down past your agreement price this does not mean that it will be automatically triggered.

Incidentally, this is one advantage of a limit order. Although you don't get paid for a limit order, it will transact if shares are trading at or below your set price. With a put option it's at the buyer's discretion.

Using the above example, shares may go to $73 in the next month. With a limit order you would buy shares. With the put option it could be exercised, but there isn't a requirement that it must. Should shares go higher after that the put option may never be exercised. This is a true risk and something that you keep in the back of your mind. It's also why it's so important to be content with either side of the agreement.

Put Option Downside #3 = You Don't Collect The Dividends While You Wait

With a covered call you still receive the dividend payments, as you still own the underlying security. With a cash-secured put you do not yet own the security and thus you do not collect the dividend payments.

You're compensated for this with the upfront premium, but it remains that this will be your only cash flow until the option is exercised or it expires.

Put Option Downside #4 = You Might Have To Redeploy The Capital

If you're a "set it and forget it" type investor, a simple buy and hold strategy is apt to be more attractive to you.

With selling puts the option does not have to be exercised. So in keeping with the example above you might wake up in January of 2017 with an "extra" $7,500 to allocate once more. Personally this is what I enjoy about the investing world, but it follows that this takes more time, thought and preparation.

Put Option Downside #5 = There Are Separate Tax Implications To Think About

If the put option is not exercised, the option premium can be taxed as ordinary (short-term) income.

If the option is exercised, the option premium becomes part of your cost basis and future tax considerations depend on how long you hold the underlying security. There's an added layer of complexity involved that is not present with buying, holding and collecting qualified dividend payments.

Final Thoughts

Selling a cash-secured put, in its simplest form, is getting paid to agree to buy at a price that you would be happy with. You might use this strategy to enhance your cash flow or to own a security at a cost that you deem is fair. If you're going to work with options, you want to make sure that you'd be content with either side of the agreement.

You might be turned off from selling put options due to the added complexity, extra leg work or apprehension about never owning a security. If you're going to be kicking yourself if shares of Deere go to $100 and you "only" received a 7% return, this is something that you should think about. The psychological barriers are every bit as real as the structural ones. The point is to figure out what may be right for you.

Personally before buying any security I like to see what's available with the put options out there. Granted this doesn't mean that I use a put option all the time, or even the majority of the time.Things come up like having to work in round lots, or not liking the terms offered or any number of additional reasons. The idea is to at least be aware of the possibilities to see if anything interesting is being offered.