The Cash Secured Put Strategy
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The cash secured put strategy is one method we are using to increase our monthly income.
We already have a few other sources of income (at the time of this writing) including – W2 paycheck, stock dividends, bank interest, and a few side hustles.
By adding this new income stream from selling options, we can take another step towards our ultimate goal … becoming financially independent.
The path to financial independence for our family will rely on several different tools.
One of those tools is to build a passive income stream of dividends in our taxable brokerage accounts.
While it is unlikely we will be able to completely live off dividends, they should help provide a steady source of passive income. Our latest projection shows that dividends should be able to cover 20% to 25% of our expenses when we hit financial independence.
So how do we get our dividends to grow to that point?
By increasing our active income sources right now from places like side hustles and selling options.
This gives us the opportunity to invest more and more disposable income into our dividend portfolio. Which ultimately will increase our current and future dividend income.
So … enough talk about our financial independence plan, let’s get to our strategy for earning income from selling cash secured puts.
Let’s take a quick look at what are options and each type – calls and puts. Then we will cover our strategy for selling puts to generate monthly cash flow.
What are Options?
Options are a derivative based on the value of an underlying security … in this case stocks.
The buyer of an option has the right, but not the obligation, to buy (call) or sell (put) the underlying stock at an agreed upon price (strike price). In exchange for this right, the buyer pays the seller (that is us) a premium (which is how we generate our income).
There are two types of options – calls and puts.
Call options allow the buyer the opportunity to purchase the stock (100 shares per contract) at the strike price on or before a certain date (expiration date).
Put options allow the buyer the opportunity to sell the stock (100 shares per contract) at the strike price on or before a certain date (expiration date).
Important options terms you should know –
Strike Price – the price at which a put or call option can be exercised. This is normally different than the current share price.
Expiration Date – the day in which the put or call option expires.
Option Type – calls and puts
Action – an investor can do one of the following actions for options:
- buy to open
- buy to close
- sell to open
- sell to close
Note – For the purposes of selling cash secured puts, we are mostly interested in the sell to open action. Sometimes we may also need to buy to close.
For more high level information on trading options, check out this – Essential Options Trading Guide.
While there are many different strategies for trading options that can make you money … or lose you money … I want to focus on one particular method today – selling cash secured puts.
Cash Secured Puts
As I previously mentioned, you can be a buyer or a seller of either a call option or a put option.
For the purposes of this strategy – we are only concerned with being the seller of a put option.
By selling an option, we will receive a premium from the buyer that is ours to keep. This is how we generate the income.
But this is not free money … nor is it as easy as it sounds.
As the seller, we are taking on the risk of having to purchase shares of stock from the buyer at the strike price. If the underlying stock price tanks, we could be forced to overpay for a stock that is now trading much lower.
This is why I have developed a set of rules to follow that will minimize our risks. Below I have laid out the steps for following our cash secured put strategy.
For a good overview on the topic, check out this article on cash secured puts.
Cash Secured Put Strategy to Generate Income
The following cash secured put strategy defined here is what we currently use to generate income. There are plenty of other successful strategies, but this is the one that works best for us.
Keep in mind the following –
We are the sellers of the put option.
By selling a put, we give the buyer the opportunity to sell us their shares (100 shares per option contract) of stock at the strike price on or before the expiration date.
In return for this opportunity, the seller (us) receives a premium from the buyer that is theirs to keep. This is how we generate our cash flow.
Of course, there are plenty of risks involved in this strategy … which is why we try and follow a strategy.
I have highlighted our steps below.
1 – Identify a List of Potential Stocks
The very first step (before selling a cash secured put) is to identify a list of stocks that I may be interested in buying. This could include stocks my wife and I already own in our portfolio … or it could be new stocks we are interested in adding.
The most important thing to remember here is that we need to be comfortable owning the stock in our portfolio. And we need to be okay with owning 100 shares of that stock.
We are long term buy and hold investors, so this is a critical step for our success. If the market turns sideways … we don’t want to be left holding 100 (or more) shares of stock in a company that doesn’t meet our investment criteria.
One last thing … we try and usually focus on owning high quality dividend stocks. However, there are other non-dividend paying stocks that we do consider using this cash secured put strategy.
2 – Figure Out How Much Cash You Will Need
This is where the “cash secured” part of the strategy comes into play. To be honest, this could be considered one of the weaknesses of this strategy as well.
For the purposes of this strategy, I am not going to discuss trading on margin or anything like that. We are sticking to cash only investments.
In order to be able to sell a cash secured put, we need to make sure there is enough cash in our brokerage account to cover 100 shares of the stock. Also keep in mind, it is 100 shares of the stock at the strike price of the put option … not the current share price.
So if we sold 1 option contract with a strike price of $25, then we need to have $2,500 (100 shares X $25) available in our account.
This doesn’t necessarily mean we are going to buy 100 shares of the stock … but we can’t get caught off guard without the funds to buy those shares.
Once we sell our put option, if the buyer of that contract decides to exercise it … then we need to buy 100 shares of the stock from them at the strike price.
And just as a reminder – 1 Option Contract = 100 shares of stock
3 – Fund Your Brokerage Account
At this point, I am going to assume you have opened a brokerage account and have access to trade options. If you do not … then you need to make that happen first.
Once we figure out a potential list of companies we can sell put options on and figure out how much cash we need … it is time to fund your brokerage account.
This step could be combined with #2, but I like to keep them separate.
For example, when we first started selling cash secured puts … we decided to fund our brokerage account with $5,000. This wasn’t any kind of magical number but rather the amount of cash we had available to use.
Using the example from above of a put option with a strike price of $25, we could technically sell 2 contracts –
2 put options * 100 shares * $25 strike price = $5,000
Or maybe we identified another company with a strike price of $45 we wanted to sell. Well that would mean we would need $4,500 in cash –
1 put option * 100 shares * $45 strike price = $4,500
Just keep in mind … to sell a cash secured put … you need enough available cash to buy 100 shares of stock (for each contract) at the strike price.
One of the disadvantages of this strategy is that you need to keep this cash available in your account in case you need it. That means … no buying dividend stocks with it in our case.
4 – Further Narrow Down Our List of Stocks
I would absolutely love to be able to sell cash secured puts on some of our favorite dividend stocks like – Costco (COST), Lockheed Martin (LMT), Microsoft (MSFT), Apple (AAPL), and T Row Price (TROW).
Only problem with that is having enough cash in our account to cover 100 shares of the stock.
For example, at the time of this writing … 1 share of COST was trading at over $440 a share!
So doing the math … we would need around $44,000 to sell a single secured put. Even if we had that kind of cash sitting around, it isn’t likely we’d want to set it aside just to sell a secured put.
This is the step where we need to be realistic in our cash secured put strategy.
In our previous step (3 – Fund Your Brokerage Account), my wife and I set aside $5,000 of cash to start trading puts.
Obviously that amount of money just won’t work for those awesome dividend stocks I mentioned earlier.
Therefore, we need to take our list of stocks we put together in step 1 and narrow it down to what will work with our cash balance.
In this case, any company trading at or below $50 per share from the list would technically fit this criteria for our example.
5 – Filter Expiration Dates Between 30 to 45 Days Out
This step is more of a guide rather than a requirement.
After selling put options for a few months now, I have found the sweet spot to be contracts that expire between 30 to 45 days out.
This does not mean I don’t sell puts that expire in week or two. In fact, many of the put options I have sold over the past year have expired within 1 to 2 weeks.
What I have found though is the sweet spot for time decay and the premium (income) the seller will receive seems optimal between 1 to 1.5 months out.
There are also a few puts I have sold that are several months out … between 4 to 6 months.
So like I said … this isn’t a requirement but more rather a rule of thumb.
6 – Out of the Money Puts
What does out of the money even mean?
When a put is considered out of the money … it means the strike price is below the current share price.
So if a stock is currently trading at $25 per share … out of the money puts will have a strike price that is less than the share price.
We all want a bargain right? So if we are entering into a contract with the buyer … we don’t necessarily want to agree to pay full price for the stock.
Instead we may sell a put option with a strike price of $24.
In the event the put option is exercised, then we’d simply pay $2,400 for 100 shares of that stock instead of $2,500.
This of course means we may end up losing out on the stock if we really wanted to buy it … if the share price stays above the strike price up through the expiration date.
But again … keep in mind that this strategy focuses on generating income first … not necessarily buying the actual stocks.
Just keep in mind that the further out of the money a put is … they less premium you will receive.
7 – Sell Put to Open
By now you should have been approved for trading options in your brokerage account. All we need to be able to perform is buying and selling puts (and calls if you choose).
We have narrowed down our stocks at this point … a couple of times.
Our cash to allow for selling the secured put has been deposited in our brokerage account.
And hopefully we have identified a few solid out of the money put options that expire in the next month and a half.
Now is the time to place a sell to open order. I usually avoid market orders when it comes to buying and selling options. Instead I place a limit order.
I have probably oversimplified this process … but these are the steps I use to sell a put option to generate income.
8 – Track and Manage Your Put Options
Now it is time to track the put option(s) you sold. Personally … I like to track my option contracts in a spreadsheet.
It is important to make sure you check in on how your put contract is doing (but don’t get too carried away). As the days get closer and closer to your expiration date … check it more and more.
There are a few outcomes that can happen –
- contract expires worthless – this is what we want to happen
- you could decide to roll the option out to a later date
- the buyer exercises the option and you buy the shares
Outcomes #1 and #3 I think are self explanatory.
However, outcome #2 gives you a little more breathing room if you need it. You could potentially roll the contract out to a further expiration date.
Basically this means you buy to close the current put option (likely more than what you sold it for). Then you turn around immediately and sell a new contract (hopefully for a higher premium).
The net result is that the two combined transactions hopefully results in a gain and not a loss.
Note – I probably use the roll outcome a little too much and don’t let the original put option get as close as it could to expiration. This likely has left potential income on the table.
Exercise the Put Option
Remember that the buyer of the put can exercise the option contract at any time on or before the expiration date. So don’t be surprised to get assigned the shares even before expiration if the stock price begins to fall. Remember … if you followed the steps correctly … this is a stock that we didn’t mind owning.
If this happens … you will be buying 100 shares of the stock at the strike price … not the current share price. And if this happens, you are most likely paying more for the stock than what it is trading at. This is one disadvantage of this strategy.
Now we can either keep the stock.
Or we could turn around and keep the cash machine rolling by selling a covered call … another option trading strategy we won’t discuss here. You could also decide to sell your shares … likely at a loss if you need the cash.
Selling Secured Put Options for Income
Selling secured put options for income is a good way to grow your monthly cash flow.
But it doesn’t some without some risks. For example, the seller (us) could be required to buy 100 shares of the underlying stock at the strike price. That means if the stock price tanks … you may be left holding on to some expensive shares. But remember … this is a company we don’t mind owning … right?
Another possible risk is that you may miss owning a really great stock that takes off. Let’s say you had planned on buying 100 shares of the stock around the strike price. What happens if that $25 stock suddenly goes to $50? Well you’d have to pay double for owning those same 100 shares.
So you could potentially miss out on buying a stock at an affordable price. I don’t see this as a big issue because our goal is income generation. If I really wanted to own that stock, I would have bought it already.
Despite a few of the risks I highlighted above, I personally see selling secured put options as a solid way to increase your monthly cash flow.
Do you sell cash secured puts? How do you limit your risks? Do you have any set of rules in place for making your trades?