What are cash secured puts?

What are cash secured puts?

The cash secured put is an option selling strategy deployed with the aim to buy the stock below the current market price. Here an investor keeps sufficient funds to buy a stock at the predetermined strike price while simultaneously selling the put option of that strike price. 

However, the one big risk involved in this strategy is that if the stock prices zoom significantly higher, investors may have to buy the stock at higher than expected prices. 

Example of cash secured put 

Let us understand this with the help of a cash secured put example. Mr. Malik is a trader. He wants to buy 250 shares of Reliance Industries Ltd (RIL) at ₹2,400 when  it is currently trading at ₹2,450. He has two options:

  • Option 1: Wait for the price to dip.
  • Option 2: Deploy cash secured put strategy.

Mr. Malik decided to go with option 2. He sells a put option of RIL of the strike price of ₹2,400 for a premium of ₹20. The lot size of the RIL options contract is 250. 

Total premium received = Premium x lot size = ₹20 x 250 = ₹5,000.

Contract value = Strike price x lot size = ₹2400 x 250 = ₹6,00,000.

As the contract value of this option is ₹6 lakhs, Mr. Malik will keep this amount in his account to buy RIL shares. Since the investor has the contract value available in cash against the put option sold, this strategy is known as cash secured put.

Let's understand what happens next with the help of the following scenarios from the put seller's perspective:

Scenario 1: At expiry, RIL is trading at ₹2,300.

In this case, Mr. Malik incurred a loss on his put option as the shares of RIL went below the strike price of 2,400. 

Loss = (strike price - spot price - premium received) * lot size = (2,400 - 2,300 - 20) * 250 = ₹20,000.

Here, the buyer has the opportunity to buy the shares in the cash market at a cheaper rate than expected.

Scenario 2: At expiry, RIL is trading at ₹2,380.

₹2,380 mark is the break-even point in this scenario, which is calculated by subtracting the strike price from the premium paid.

Break-even point = strike price - premium = ₹2,400 – ₹20 = ₹2,380. Profit = 0. 

This point is the same for the buyer and seller. So, Mr. Malik’s profit is also zero.

Scenario 3: At expiry, RIL is trading at ₹2,400.

As the spot price is equal to the strike price, the seller can not only pocket the premium, but also buy the stock at that price on expiry.

Profit= Total premium received = Premium x lot size = ₹20 x 250 = ₹5,000.

Mr. Malik gets to buy the shares at ₹2,400 which he wanted. In fact, the profit on put options effectively further lowered his buying price to ₹2,380.

Scenario 2 and 3 are the ideal cases for investors selling cash secured puts. 

Scenario 4: At expiry, RIL is trading at ₹2,500

In this case, the spot price moved ₹100 higher than the strike price. As the spot price has ended up above the strike price, the seller keeps the whole premium amount.

Profit= Total premium received = Premium x lot size = ₹20 x 250 = ₹5,000.

Here the investor has to buy shares at much higher prices. The profits earned through selling put options cover only a part of the increase in share price. 

Payoff Schedule for the put option sold

RIL @ Expiry

Net Payoff (Rs)

2300

-20,000

2320

-15,000
2340

-10,000

2360

-5,000

2380

0

2400

5,000

2420

5,000

2440

5,000
2460

5,000

2480

5,000
2500

5,000

Payoff Chart

 

Remember: Cash secured put margin requirement is the same as that of a normal put. However the contract value being available in the investor's account is what makes it a cash secured put. 

Selling cash secured puts and covered calls 

These are two different strategies. In selling cash secured puts, an investor has to have funds equal to the contract value in the investor's account to buy a stock at the predetermined strike price while simultaneously selling the put option of that strike price. While a covered call strategy refers to selling a call option of a security that the writer already has a long position on in the cash market or in futures. 

So to summarise:

  • If the trader selects the correct strike price, he will not only receive the premium but also be able to buy the shares at expiry or he may continue selling cash secured puts for income.
  • Selling weekly cash secured puts is not an effective option in India as weekly options are available only for Nifty 50 and Bank Nifty and not stocks. And this strategy is primarily for lowering the cost of purchase of stocks. 

 

  • Premium earned helps offset the cost of purchasing the shares in the cash market.

 

  • This strategy cannot be adopted if an investor has to take cash positions significantly smaller than the option contract value.

 

  • This strategy can only be used for stocks on which options are traded.

 

  • If the share price remains high, an investor may end up buying them at a much higher price than anticipated.
×

The future of investing is here!

Open demat & trading account in 10 mins

+91