JJ Kinahan, Chief Market Strategist at TD Ameritrade, is joined by guests to cover the ins and outs of the cash-secured put option trading strategy.
This is Understanding Options. I'm your host, JJ Kinahan.
JJ: Hello everybody. I'm JJ Kinahan, Chief Market Strategist at TD Ameritrade. And welcome to Understanding Options. I'm joined by two of my favorite guys today, TD Ameritrade Education Coaches Ben Watson and Pat Mullaly. Hello, guys.
Pat: Hey, JJ.
JJ: Our topic today, cash-secured puts. So Ben, it sounds like a very complex subject. But I think we can help people break it down and show that it's really not the most complicated thing in the world. You want to maybe explain how this works?
Ben: Absolutely. And I think you're right. If we break it down into its components, I think it makes a lot of sense. When we talk about cash-secured puts, remember, selling a put creates an obligation. It obligates the investor to buy or basically halve shares of the stock put to them at that strike price of the option all the way out through the expiration date. Now, the put owner, somebody that buys the put, wants the stock price to move lower. But the put seller, or the writer of the put, wants the stock price to move higher, because in most cases, they don't want to have to satisfy that obligation of being put the stock.
Now, cash-secured puts are a form of put writing or selling. But the investor has enough funds in their account to cover the cost of buying the shares of the stock if that obligation is assigned to them on the short put and they have to end up buying those shares.
JJ: That's a great overall explanation. Thanks, Ben. So Pat, let's talk about some of the risks and rewards of a put writing strategy.
Pat: OK, so the benefit, what a lot of people look at is the premium that they get for writing those puts. So their main motivation typically is going to be that premium. But let's be careful here. They have to be willing to buy that stock. So they've got to not mind buying that stock at a price that they're writing that put at, because again, like Ben said, you have the obligation to buy that stock.
Now, if the stock stays above the strike price of that particular option contract through expiration, that expires worthless, that option expires worthless, and the investor gets to keep the premium. And that sounds great, but they have to be comfortable to buy that underlying stock at that strike price over the put that was sold. So very important to keep your eye on that.
Ben: So Pat, another benefit to writing or selling put options, you might use this strategy to get long stock at a reduced price, basically using this as an opportunity to buy the stock, bring in that premium, and offset the purchase price of the stock a little bit.
Pat: So effectively lowering the purchase price of that stock.
Ben: Exactly, so you could sell puts at a strike price below the market value. And if things go well in this scenario, you could buy the stock at somewhat of a discount, right? Of course, if the option isn't exercised, you simply keep the premium received for selling the put option.
Pat: Yeah, and you bring up something there, buying it at that lower price. And a lot of people-- and JJ has mentioned this before-- limit orders. So somebody might put a limit order in to buy a stock below where the stock is trading because they want to buy the stock at a more preferable price. However, maybe the stock goes up, and they miss buying the stock. Here you could use this as maybe a limit order of sorts, but collect a premium to do it.
JJ: Yeah, and I do like this strategy. And as with many of these strategies, you can compare them to things you already know. And most people I think already understand what a limit order is. Of course, the bigger difference is this is going to be a lot harder to cancel if things are going against you. So that's why it's really important in starting out by saying, I want to buy this stock at this strike price. And it's where all the charting and fundamentals that you use can really come into play. So for that point of view, I do like to use this strategy for stocks that I own, the underlying theme always being I'm a willing buyer at the strike price that I sold.
So we just seemed to talk about the benefits of it and why it can be a winner winner, chicken dinner. But let's now talk on the other side. And Ben, many investors shy away from doing this because, as we stated, some say it's too risky. What are some of the risks involved with doing something like this?
Ben: All right, so let's talk about some of those potential risks and rewards of selling puts. It's similar to owning stock, because in the scenario that you just talked about and the situation where the options seller ends up having to buy the stock or having the stock put to them, now they have the risk of that stock ownership. And the price of the stock could go all the way to zero.
Now, since it's a cash-secured put, the assumption is that the investor has the cash in the account to buy the shares. They get the shares in their account. Now, that cash-secured put strategy purchases the corresponding stock at the strike price when the market price of the stock will likely be lower and maybe even continuing to go down. So there's that risk that the price of the stock could continue to go all the way to zero, perhaps, in some cases. And that's where that risk is.
Pat: Yeah, yeah. And so that risk-- and we talk about naked options all the time, and naked options strategy. So if somebody goes out and sells a put not thinking about buying the stock, like you said, that could effectively go to zero. And they would end up having to buy that stock. Somebody would put that stock to them at a greater loss. So there's a high amount of risk. And where that risk really comes into play is they may get greedy. They may think that, yeah, there's no way this is going to go any lower. They sell an inordinate amount of puts, more than they would be willing to buy, more puts than they would be willing to buy the stock. And that's where the problem comes in.
So when you have that, like you're saying, that cash-secured put, rather than a naked put, you're going to look at this as a process. You're going to say, well, if I'm going to buy shares of stock, how many shares of stock would I want to own? I've got x amount of dollars. I certainly don't want to put every dollar I have into buying this stock. I would want to buy maybe 10% of that, of my portfolio in this stock. And you might sell puts that would cover that 10% of your portfolio risk.
Ben: And that's just an example in this case, not any kind of recommendation to allocate--
Ben: --in your portfolio. But as you look at that again, that risk becomes really the risk of owning the stock and the price of the stock falling from wherever you bought it all the way to zero.
Pat: And remember, you do get to keep that premium.
JJ: And I like that you guys are bringing up both those, because one of the things I like about the strategy is it makes you really do good position management, and also not biting off more than you can chew, so to speak. And let's face it, it is a defined risk, in one sense. You know the stock can go to zero. You know what you can lose going in. That's the ultimate example of defined risk.
Pat: It's got great support at zero.
JJ: Well, yeah. And hopefully, if you're buying a stock or investing in any stock, you don't think there's a high probability it could go to zero. But anyway, all of that being said, the most important thing about this is to really learn what you can about any options strategy you're going to use. I wouldn't say go out and learn all about every option right away, because it'll be like drinking from a fire hose. But if you're going to use this strategy, really understand the risks and rewards.
And the problem most people have when they start out is they really understand the rewards well, and they tend to ignore those risks. Good investors, good long-term traders always understand risks first and then say, is there enough reward to make the risk worthwhile? So guys, as always, thank you for sharing your knowledge. Always a great time spending it with you two and helping our clients learn more about what they can and can't do in the world of options. So thank you, guys.
Ben & Pat: Thank you.
JJ: And you can also find more option education at essentialoptionstrategies.com. You can find me on Twitter @TDAJJKinahan. You can find Ben on Twitter at--
Ben: @BenWatson_TDA, also on Twitter.
JJ: And you can find Pat Mullaly wherever there's smart talk about investing and options at the TD Ameritrade Education site. So thanks mostly to you, our listeners, for joining us today. Hope you enjoyed it as much as I did. Good luck in all your investing, and good trading everyone. Thank you.
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