Selling a cash-secured put means that you sell or "write" a put option against shares that you do not yet own, but would like to own. In an IRA account the short put must be cash secured, which means that you must have enough cash in your account to buy the shares of they are put to you.
Not only must you have enough cash in your account, but during the whole time you are short that put, the cash will be frozen in your account and you cannot use it for any other trade or as collateral for any other option position.
1 option represents 100 shares, so you need to be able to buy a minimum of 100 shares,or a multiple of 100 shares to sell a cash-secured put.
Why write cash-secured puts?
Typically when the IRA investor sells cash secured puts he or she is either hoping to be able to buy a stock for a cheaper price than that at which it is currently trading, or he or she is interested in generating extra income via the sale of the option premium and sells a put at a price where he or she does not expect to be assigned the stock.
If the strike price of the option sold is lower than the current price of the stock, the investor would normally hope that the option expires worthless with the stock price above the strike price of the option. In this case the investor will keep the premium received as income.
Let's see how this could work with an example. Let's say we have enough cash to buy 100 shares of Apple Inc. (NASDAQ:AAPL). We love the company and have read several articles on Seeking Alpha discussing the idea that it is only a matter of time before the stock hits $1000.
Click to enlarge.
The stock is currently at $582.13, but we would like to buy the stock a bit cheaper. The June 15th $550 put option bid price is $11.55 per share, which means that since each option represents 100 shares, we can sell 1 option for $1155, which gives our putter the right to sell us 100 shares of AAPL for $550 each.
This looks like quite the bargain as the stock is worth $582 today and someone will give us $1155 just to promise to buy the stock for $32 per share less than the current price. They must be nuts!
Of course, to do this, we will have to set aside $55,000 (ouch!) in our account just in case the stock is assigned to us at a bargain price of $550.
If the stock does not go down to $550 by June 15th, we will be a little bit sad that we didn't get our shares of AAPL for $550, but at least we kept the $1155 which is a 2% gain on our money in only a month and a half.
So why doesn't every one do this? Well, a lot of people do. For example, Warren Buffett (though not, as far as I know, with AAPL stock). But there are risks too. $550 sounds like a bargain price for AAPL when the stock is $582, but supposing the stock suddenly falls to $450 for some reason, for example a huge earthquake in Cupertino, CA, or a terrorist attack on a Foxconn factory, then you are still on the hook to buy the stock for $550 and you are looking at a $10,000 loss just to gain $1155. Was it worth it?
If we have consulted the Almanac and we don't like the look of our prospects, we could limit our risk by entering into a spread. How does this work? Lets go back to the options table and check out some more put prices.
We see that the June $500 put is offered at an ask price of $3.25. If we sell the $550 put for $1155 and buy a $500 put for $3.25 at the same time, we reduce our credit from $1155 to $830, which is the difference between the two prices, but we also reduce our potential risk from $55,000 to $10,000, so that if that earthquake occurs, we won't fall through the cracks.
Because ownership of the lower put gives us that insurance, we don't have to put up $55,000 earnest money, but only $5,000. So now if nothing untoward happens and AAPL stay over $550 on June 15th, we will make $830 for the $5,000 that we have at risk, which is $16.6% in a month and a half. Jeepers, that means we are being paid an annualized rate of 132% to be willing to buy AAPL for $550.
Or if the stock goes below $550, we will break even at $541.70, and if it goes below that point we will be showing a deficit on the trade, but at least we will be able to buy 100 shares of AAPL for $550, which is what we wanted in the first place - so that we could ride the stock to $1000.
Astute readers will perhaps see where the danger lies here. When you can get 66% for your money, why not put all the money in your account in this one trade and in not much more than a year, you could double your account?
The problem here is that you could also wipe your entire account out completely if you get overextended. It would not even necessarily take an earthquake or a terrorist attack. It could just be a generalized world wide economic malaise that affects all high-flying stocks, or something that no one ever expected. It could just be a failure to beat earnings estimates.
Still, no one ever got a 66% return without some risk, which is why there is currently an open interest of over 8000 June 15th AAPL $550 puts representing well over $400 million worth of stock.
Disclosure: I am long AAPL.