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What are Cash Secured Puts and How to Use Them

Introduction

  • The stock market is not just a place for big, long-term investments; it can also be utilised to generate a regular source of income.
  • Smart traders have a bunch of options at their disposal to trade and earn consistently from the market.
  • There are many strategies available for the deft use of futures and options to earn good returns, and cash-secured puts are one of them. 

What is a Put Option?

First, we must understand a put option to know what a cash-secured put is. A put option is a contract that gives its holder the right to sell an underlying asset at a pre-determined date and price. This pre-decided price is also known as the strike price. However, the sale must take place within the expiration period of the contract.

What is a Cash-Secured Put?

Now that we understand what a put option is, let us take a look at a specific type of put option, i.e. the cash-secured put.

  • The cash-secured put comprises writing (selling) a put option and, at the same time, amassing enough capital to purchase the underlying.
  • Here, the investor gets to secure a premium from the buyer. In simple terms, the investor makes the promise of purchasing an asset at a predetermined price, which is lower than the current strike price, in return for a premium. 
  • In most cases, the investor wants to purchase the asset anyway. Hence, being able to purchase at the strike price is often the best-case scenario for an investor.
  • Let us now understand the workings of a cash secured put strategy with the help of an example:

 

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You, as an investor, wish to purchase 100 shares of Company X. It is currently trading at 1500, but you wish to purchase it at 1450. Now you have two options: wait for a dip in the price or initiate a cash-secured put strategy. 

Let's say you decide to go with your second choice. You now have to sell a put option for Company X at the strike price of 1450. You receive a premium of 10. Your lot size is 100. Hence, the total premium you receive will be 100 * 10 = 1000. The overall value of the contract will be 1450 * 100 (lot size) = 145000.

You will have this entire cash amount at your disposal. This amount can be used to buy the shares of Company X that you wanted to purchase in the first place. 

(All amounts are in Indian rupees)

What are the Possible Scenarios after Initiating a Cash Secured Put?

Four situations may arise. Let us take a look at each one and their outcomes:

  • Company X is trading for 1300 when the contract expires. In this case, you will suffer a loss, as the share prices went below your strike price. Your loss will amount to strike price minus spot price minus premium * lot size = (1450–1300–10) * 100 = 14000.
  • Company X is selling shares at a break-even point: The strike price and spot price balance each other out, taking the premium into account. Your profits in this case will be nil. 
  • Company X is trading at a spot price of 1450: In this case, you can not only keep the premium you earned but also buy the shares at the strike price, for which you put aside the capital. This is an ideal scenario.
  • Company X is trading at the spot price of 1600: When the spot price rises far above the strike price, the premium is also used to buy the stocks. In this case, the investor suffers a loss acquiring the stocks since the premium only covers part of the extra capital required.

Closing Thoughts

  • In a nutshell, the cash-secured put strategy has its advantages and disadvantages.
  • Although it allows you to gain a premium easily and reinvest your gains, there are risks associated with it too.
  • You might miss buying opportunities, and there could be tax-related expenditures on the trade.

All in all, the cash-secured put strategy is the safer way of generating constant cash flow from the market.

 

Related Articles: How to Open a Demat Account Without a Broker | Factors to Keep in Mind While Opening a Demat account | Factors to Consider When Opening a Demat Account | 10 Points to Remember When Operating your Demat Account | Types Of Demat Account & Trading Account

 

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