A key to weathering – and potentially profiting from – a market correction is planning and implementation.
Using Cash-Secured Puts to Help Generate Income
Cash-secured puts can be used to produce income (through the premium received) or to possibly purchase the underlying security at a lower cost basis than the current market price.
When you sell short or write a cash-secured put, you must have enough money in your account to cover the potential purchase of the underlying security. You receive a premium from the buyer, but the option may be assigned, meaning you would be required to buy the underlying stock at the option strike price. The cash reserve must remain in your account until the option position is closed or the option is assigned.
Selling short (or writing) a cash-secured put is considered a neutral to bullish strategy. If your objective is to profit solely from the premium, you would likely have a bullish outlook for the length of the option's life. If your objective is to acquire the underlying security you would likely have a longer-term bullish view.
What happens if the option is in the money at expiration?
If the put option is 1 penny ($0.01) or more in the money (meaning the market price is lower than the strike price) at expiration, the option will likely be assigned and you will be obligated to buy the underlying security at the put option's strike price.
What happens if the option is out of the money at expiration?
If the put option expires out of the money (meaning the market price is higher than the put strike price), the option expires worthless and your obligation to buy the underlying security expires as well. You will retain the premium.
How to Calculate Max Profit, Break-Even and Max Loss
The maximum profit from a cash-secured put is the premium received, minus commissions and fees. The break-even point is the strike price less the option premium received, or the price at which you would start to incur a loss. The maximum loss assumes you would purchase the underlying security and its price falls to zero. The loss would be partially offset by the premium.
Profit and Loss Graph
This illustration is hypothetical and does not reflect actual investment results or guarantee future results.
The following factors will influence an option's premium and should be considered when implementing an option strategy.
- Volatility: Periods of higher-than-normal volatility tend to cause option premiums to rise. Periods of lower-than-normal volatility tend to cause option premiums to decline.
- Time Decay: The value of an option declines to its intrinsic value as it approaches expiration. The rate of decline increases as the option gets closer to expiration. Time decay can benefit the seller of an option and be a detriment to the buyer.
- Delta: Delta helps measure the amount that an option's price could change relative to a one-point move in the underlying security's price. Out-of-the-money options tend to capture less of a price move than in-the-money options.
- Assignment: Assignment happens when the owner of the put option exercises his right to sell the underlying security at the option's strike price. Assignment can happen at any time with an American-style option, but is unlikely if the option is out-of-the-money or still has time value built into the option's premium. A European-style option can only be exercised/assigned at expiration.
Examples used will not show the deduction, or inclusion, of commissions and other costs that may significantly affect the performance of the given strategy. They do not take into consideration tax consequences or fees with minimal impact on a given strategy. An investor should understand the impact of transaction costs, margin fees and requirements, and tax considerations before entering into any options strategy. Consult with your tax advisor for information on how taxes may affect the outcome of these strategies. Keep in mind profit will be reduced or loss worsened, as applicable, by the deduction of commissions and fees.
More Articles & Insights
A reasoned trading plan can help you overcome your emotions and add discipline to your buy and sell decisions.
Learn about extended hours trading at Scottrade and how trading differs outside normal market hours.