Cash Secured Put: Generating passive income the right way

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Cash Secured Put

Selling cash secured puts is typically one of the most common option strategies to generate a steady stream of income on a monthly basis for your underlying stock.

There are two ways you can play it: Short-term using a trading mindset or long-term using an investing mindset. What do I mean by that?

If you are a value investor and wish to purchase a stock that you like (and willing to hold for the long term) with a certain level of “margin of safety” or MOS for short, you might want to SELL a cash secured put on the stock. If the stock dips below your Sell Put Strike, you are OK with ownership of the stock (with the cost being the strike price level).

Additional Reading: 4 Option Trading Strategies for Beginners

Quick example: AAPL

Assume you wish to own AAPL for the long term but believe that $120 is a fair price to pay for the counter. AAPL is currently trading at $126. So, you sell 1 cash-secured put contract with a strike price of $120, with the option contract expiring in 1-month time.

As a seller, you are entitled to a premium that goes straight into your pocket. Let’s say it is $100/contract. If after 1-month, AAPL’s share price dips to $115, you are now OBLIGATED to buy 100 shares of AAPL for $120/share for a total outlay of $12,000. Your current P&L is -$400.

Cash secured in this case means that you have the necessary capital to take ownership of 100 shares of AAPL. So, you will need at least $12,000 cash in your account when you are engaged in this cash secured put strategy on AAPL.

You are, however, fine with taking ownership of AAPL at $120 ($6 MOS from the current price when you execute the option trade) with a long-term horizon in mind.

Additional Reading: Why value investors should also be options traders

If you are however engaging a trading mentality when you sell the cash secured put, then you should not have “only sell puts on stocks you want to own” mindset as a safety net.

Instead, you should have a trading strategy when selling a cash secured put. I will elaborate more on that later.

For now, let’s briefly talk about what selling cash secured put entails.

Selling Cash Secured Puts

Selling cash secured puts is considered a neutral to slight bullish strategy. If you believe that Stock ABC will not have much downside, but neither will its upside be significant, then you might wish to Sell a cash secured put on ABC to benefit from this scenario.

By selling a cash secured put, you receive a premium and that premium is not your MAX profit potential.

3 ways that you can make money out of the trade:

Scenario 1: ABC appreciates from the current market price level and your Put expires worthless. As a seller, you want your cash secured puts to be sold earlier to expire worthless (Sell high, buy back at ZERO). You make money in this scenario.

Scenario 2: ABC remains flat and above your option strike price. Again your underlying stock put expires worthless and you make money in this scenario.

Scenario 3: ABC dips slightly from the original level but still above your option strike price. Your put expires worthless and you make money in this scenario. Hence you generate passive income this way.

Scenario 4: ABC drops substantially from the current market price level and is now below your option strike price. Your put is now ITM and you might be losing money in this scenario.

Maximum gain

Your maximum gain is the premium that you received. No matter how much the stock appreciates, the premium that you receive is equivalent to your max profit.

Maximum loss

Your maximum loss happens when the stock goes to zero and for that reason, the risk of selling cash secured put is very similar to outright ownership of the stock.

Max loss = (100 shares * Option Strike Price) – premium received.

The max loss is partially offset by the premium you received when you sold the cash secured put option, but that is still substantial.

Breakeven Price

The breakeven price is calculated by taking the strike price less the premium received. So if you sold AAPL at a $120 strike and receive a premium of $1/share (or $100/contract since each option contract is equivalent to 100 shares), then the breakeven would be:

$120 (strike) – $1 (premium received) = $119.

The beauty of a cash secured put strategy is that when done right, this is a strategy that can consistently generate passive income for you on a monthly or even a weekly basis.   

When and how should you sell a cash secured put?

Suppose you are neutral to slightly positive on a stock such as MCD (if you are engaging a trading mindset) or positive on the underlying stock for the long term (investing mindset), you might thus wish to sell a cash secured put on MCD and generate income from this trade.

Besides stock selection, which is more critical for trading vs. investing, there are few other things to consider when deciding when might be the best time to sell a cash secured put.

Ideally, you want to sell a cash secured put when the implied volatility of the stock is high. This will mean a higher premium received. Remember that your goal as a seller is to Sell HIGH and Buy back LOW or ZERO. When a particular counter has elevated implied volatility, that feeds into its premium which means that the premium you are receiving from the sale will also be elevated.

So, the best time to sell is when implied volatility is high.

Usually, this occurs after a stock has seen a substantial big drop which can also mean the investor can purchase the shares at a lower (more depressed) price.

Implied Volatility

Take for example the counter VIPS which was recently sold off BIG TIME because of hedge fund Archegos which met with a margin call and that resulted in their portfolio stocks being sold off en-mass by their brokerage bankers.

Not only did VIPS shares drop substantially, but it also resulted in its implied volatility rising substantially as well.

That was the time I put on my trading hat and sold cash secured put on VIPS to take advantage of the elevated Implied Volatility.

At the time of my cash secured puts option sale, VIPS was trading at $31.53. I sold 1 cash secured Put at a strike of $28 (this means I have the obligation to take ownership of 100 shares of VIPS if it dips below $28 on expiration at $28/share), generating a premium of $120, for a contract horizon of 17 days.

In this trade, I enjoy a MOS of approx. 10% ($31.53 – $28 = $3.53), my net premium of $120 over 17 days translates to an annualized return of 92%.

With 10 days left to expiration, VIPS is now trading at $31.50 which is virtually flat from my entry level. However, the option premium for VIPS at the strike of $28 has now declined to just $35/contract.

This means that even though the share price has not moved much from its original level, I can now buy back the contract at $35 and generate a net profit of $120 – $35 = $85 from this trade.

Why is the profit possible when VIPS share price is essentially flat?

2 forces are at play. First, there was a collapse in Implied Volatility when the Archegos event died down. This benefitted me as a Seller. Second, time value decay or theta decay is working in my favor.

Theta Decay

All options have time value before expiration. As a seller of an option, you want the premium to decline to ZERO as fast as possible. Hence, if time value decay or theta decay is fast, that is when it works best for you as a seller.

Theta decay is typically the fastest nearest to expiration. Hence, when there are only a few days left to the contract, you can expect theta decay to be the highest.

In terms of time frames, some trades will look to sell weekly puts while others will look at 30-45 days to expiration as a sweet spot. I tend to execute my put selling trade typically with 30-45 days as my time horizon. This tends to balance out the premium received (lower for weekly puts) and the pace of theta decay.

For the VIPS trade, I was able to sell the option at a much shorter horizon and yet still able to generate an extremely attractive premium because its implied volatility is very elevated due to the unusual event of the forced sale.

Weekly vs Monthly cash secured puts

To summarize, weekly cash secured puts benefit from higher theta decay, which is good for option sellers. However, it also requires a lot of active management and may not suit someone who wishes to spend just a small amount of time generating some passive income every month.

The other downside of selling weekly puts is that while the time decay is faster, the total amount of premium generated is much less (less time value present to expiration = less premium received). This provides less of a cushion in terms of break-even level.

Take for example our AAPL example trading at $120/share.

    

While selling a 5 DTE (days to expiration) contract generates the highest annualized return, it has the lowest protection in terms of breakeven level and might require active management and repair.

On the other hand, a longer DTE like the 200 DTE contract typically has the lowest annualized return and will not benefit much from theta decay but has the greatest MOS in terms of breakeven level.

It is up to the individual investor to find a style that suits their risk tolerance. I would go for the 30 DTE contract which typically enjoys the “best of both worlds”.

Other technical factors

Besides the stock selection process and taking into account the counter’s implied volatility, I also do consider other technical factors such as support and resistance of the counter, the probability for a rebound, etc when timing the cash secured puts sale.

Risk in selling cash secured puts

I earlier highlighted that the max theoretical risk of selling a cash secured put is similar to that of owning the stock outright, that is if the price of the counter drops to ZERO.

While this scenario is highly unlikely, substantial losses can be incurred even if the counter drops by 30-50% which is increasingly common for many growth stocks in today’s context.

For example, while I might love to own Tesla, I would exercise caution in heeding the advice of financial gurus who advocate selling puts on Tesla to generate income on a “high quality” counter.

First, selling cash secured puts on a “high price” stock like Tesla will entail a potential capital outlay of >$60,000 and this amount is something out of reach for many beginner options traders.

Second, while an option seller of Tesla might benefit from the inherently high implied volatility typically present in the stock, it is more relevant to look at a counter’s implied volatility RANK when determining if it is the ideal time to sell a put.

Third, Tesla being “high quality” is subjective. Tesla will never be viewed as high quality by a value investor, especially when the stock’s profitability is determined by how much green credits it is selling vs. EV cars that the company is selling.

One should be prepared for a substantial price decline if Tesla, for whatever reasons, disappoints investors. In this case, selling cash secured puts, which is more of a neutral to slight positive strategy, might not be the right one to engage for a counter like Tesla.

VIPS trade example

Let’s take a look at our VIPS example which I highlighted earlier.

Here are the full details:

Trade Date: 30 Mar 2021

Underlying Price: $31.53

Option Trade: Sell 1 VIPS 16 April 28 Put @ 1.20

Net Credit: $120

Capital at Risk: $2800 – $120 = $2680

As highlighted earlier, when selling the cash secured put on VIPS, the implied volatility RANK of the counter is high, which was an ideal scenario.

Plugging the details into my option calculator spreadsheet, I want to double-check that the return is acceptable and that the trade is a GO based on certain parameters which I set.

The annualized return is an extremely attractive 92% and my risk on my portfolio of $50k is just 5.6%. This is way below my threshold of 20% on a cash secured basis.

My breakeven cost for VIPS is $26.80.

This trade is currently still in play as I craft this article, with its expiration on 16 April.

If VIPS remains above $28 on 16 April, the put will expire worthless and I get to profit the full $120.

If VIPS drops to say $25/share on expiration, I will now be obligated to purchase 100 shares of a cost of $28/share for a cost outlay of $2800.

My unrealized losses in this case will be $2500 – $2800 + $120 = –$180

Do you need to take ownership of VIPS for $28/share?

Options are a flexible tool and even if the situation is unfavorable to us, we can look to “rescue” the trade without having to take ownership of the stock outright.

This is called Rolling the contract where we extend the contract horizon from 16 April in this case to a further horizon while yet still generating a net credit out of it which goes to further reduce our breakeven level.

So the truth is we don’t really need to take ownership of VIPS at $28/share. In fact, you can use a simple technique to potentially reduce your breakeven level even further from the current breakeven level of $26.80/share (yes, even when the trade goes against you).

Conclusion

Selling cash secured puts has the benefit of generating a premium upfront from a stock. For longer-term investors, this can be a useful strategy to purchase a stock you like with a MOS in place.

For short-term traders, this can be a good way to generate a consistent stream of passive income, if done in a right manner.

The downside risk of selling a cash secured put is similar to direct ownership of the stock. Losses can be substantial if there is a substantial decline in the price of the underlying. That is why it is critical that one does not over-leverage when engaging in put selling options strategies.

Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.