Do you use good-til-canceled (GTC) limit orders to bid for stock below the current market? Many investors do. After deciding they are going to buy a stock, many investors will place a bid below the current market price, hoping for a dip in the stock price. This way, if they end up buying the stock, they feel as though they got the best deal possible.
But there’s also another way. Using options, you can receive money today for being willing to assume the obligation of buying stock at a lower price of your choice.
It may seem a little counter-intuitive, but you can use short puts to buy stock. This options strategy is referred to as the cash-secured put.
How it works
(1) You find a stock (or ETF) you would like to buy.
(2) You determine the price at which you’d be willing to purchase the stock.
(3) You sell a put option with a strike price near your desired purchase price.
(4) You have on deposit in your brokerage account an amount of cash equal to the potential obligation.
(5) You collect (and keep) the premium from the sale of the put, while you wait to see if you will buy the stock at the lower price.
Let’s take a look at the possible outcomes of this strategy. If the stock price goes up or remains unchanged, you won’t buy the stock, but you do keep the premium you collected from selling the put. If the stock price is below the strike price at expiration, you will buy the stock at the strike price, and you keep the premium you collected from selling the put.
The risk when selling cash-secured puts is if the stock price falls significantly below the strike price. Since you are obligated to buy the stock at that strike price, you would be purchasing stock above the market value. This is also true of placing a GTC order below the market; if the stock price drops significantly, you will buy the stock as it continues to go lower.
There are some differences between a cash-secured put and a limit order bid below the market. First, with the cash-secured put your effective purchase price of the stock is reduced by the premium you collected from selling the put; and second, if the stock price doesn’t get down to your desired purchase price, with the cash-secured put you are still collecting a premium. However, if negative news were released when the market is not open, an open limit order can be canceled if you no longer want to buy the stock; if you have a cash-secured put and you want to avoid the obligation to buy the stock, you would have to wait until the market is open to close that position.
Let’s assume stock XYZ is currently trading for $96 per share. You would like to buy 200 shares of stock XYZ if it drops to $90. You could place a GTC limit order to buy 200 shares at $90 and wait to see if you buy the shares. Or, you could sell two XYZ 90 puts at $2.25 and collect $450 (2 X $2.25 X 100 = $450) on your willingness to buy 200 shares at $90. With the cash-secured put, you can generate additional returns in your portfolio by collecting a premium for your willingness to be obligated to buy a stock at a price that is below current market.
One question many traders may ask is, “How does someone choose what strike price to sell?” Ask yourself, at what price would you be willing to buy the stock? While that may be a simple answer, it may not be easy! To help traders decide, there is a mathematical tool available to you. That tool is called Delta.
What is delta?
There are three definitions of delta, which are all true. It is the expected change in the value of an option’s price for a $1 move higher in the stock price; it is the percentage of price risk of stock ownership that is currently represented in the option; and it is the approximate probability that at expiration the stock’s price will be lower than the option’s strike price, and you will be obligated to buy the stock.
It is the third definition that can really help you choose what put to sell. You can use the option’s delta to determine the chance you will buy the stock. If you want a lower probability of having to purchase, you could consider selling 20–25 delta puts; if you wanted to increase that probability you could consider selling 30–35 delta puts.
Once you have decided which puts you want to sell, and you have sold them, you do need to monitor your position. It is important to note that you do not need to wait until expiration to see what happens. The Golden Rule of options trading is that you can always unwind, or close, your options position before expiration. Just because there’s an expiration date attached to the options trade, does not mean you have to hold it until that date. If the trade is profitable and you want to take your profits earlier than expiration, then do so! Conversely, if you experience losses on the trade and you want to limit further losses, you can always close the trade.
The cash-secured put is a powerful options strategy that may help you generate income on your willingness to bid for stock below the current market. Open an account to start trading options or upgrade your account to take advantage of more advanced options trading strategies.