Cash secured puts
Let's say you've found a stock/instrument that you're interested in buying. As of today, the price is above what you would like to pay for the instrument. Maybe it is technically overbought? The price is too high in relation to the fundamentals? There may be many reasons.
You are interested in buying the stock when the price is "right". Ordinary traders and investors tend to wait and have the order ready if the stock falls to the "desired" level.
But did you know that there is a strategy that allows you to make money during this waiting? You actually never have to own the stock and still make money on it. But how?
Gain profit while waiting for the stock to be "correctly" priced
This is where "cash-secured puts" come into the picture. This strategy is very simple but effective. When you sell/issue a put option, you take on the obligation to buy the underlying stock at an agreed price called "strike price". The investor "on the other side" of the trade, pays you a sum called "premium" for you to take on this obligation.
So back to this stock you wanted to buy. Let's say you want to buy Netflix, today's pricing is in your eyes a little too high at 658$ a share. Based on your fundamental and technical considerations, a "fair" price of the stock is 600$. You can then sell a put option with a "strike price" of 600 and with an expiration date equal to for example 30 days. The investor on the other side is willing to pay you let's say for this imaginary trade 5$ per option contract.
1) So what happens now? Let us take a few examples. The Netflix stock is at 650$ after 30 days:
The underlying price has stood still, and has never come down to the "strike price". You still get $ 5 per. contract, and are not obligated to buy the stock.
2) The Netflix stock is priced at 700$ after 30 days:
The underlying price has only risen, and has never triggered the "strike price". As with the case above, you get your 5$ per options contract and do not have the obligation to buy the stock.
3) The Netflix stock is at 600$ after 30 days:
The underlying price has fallen enough to trigger your agreed "strike price". You have accepted the obligation to buy the share at 650$, which was agreed upon when selling the option contract. Since you received a premium equal to 5$ to take on this trade, the effective price for the shares you must buy equals 645$.
cash secured puts what is a cash secured put hedge with cash secured puts
As you can see from the image, there is the possibility of an "Unlimited/100% chance of loss" by selling/issuing put options. But if you think about it, you would have received this loss anyway if you had bought the share via the market and owned it during this decline.
So if, as mentioned above, you had intended to buy this stock when it dropped to a certain level, then you might as well make some money along the way? Let's have a thought experiment:
You want to buy the stock XZ, the current price is 120$. You think 80$ is a "fair" price and will buy the stock for that amount. Instead of buying the stock if it drops to $ 80, you decide to run this "cash-secured put" strategy.
You get 5$ to issue put option contracts with a "strike price" equal to 80$, with an expiration date equal to 30 days. The first time you make the trade, the stock stands still and is at 120$. The second time you do the trade, the stock is at 130$ after 30 days. The third time you perform the trade, the stock is at 100$. You get a slightly higher premium the last time you do the trade. This is because the price of the "strike price" and the stock price of the underlying instrument are so close to each other. The investor on the "opposite side" pays you 6$ for selling him the option contract. After 30 days, the price of the underlying stock is at 78$. You then had the obligation to buy it at your agreed "strike price" equal to 80$. But what was the math overall?
You received 3 periods of payment, while you waited for the stock to come "down" to a "fair" price based on your fundamental assessments. The total "income" from these periods was: 5 + 5 + 6 = 16$.
You thus "only" paid 80 -16 = 64$ for the shares, whereas the current price is 78 $ dollars. This must be a fair price for a stock you had already put away money for to buy at 80 $?
As you can see, it is possible to perform good trades as an issuer of put options. You can really think of yourself as an insurance company. You make money all the way, but if the stock price reaches a value that you have already calculated as acceptable, then you get to buy the stock at this price.
By using this strategy, you can in theory make money on a stock over several years, without ever owning it. This is in cases where the put option is never exercised, as the underlying share price never reaches the levels of the "strike price". Many large investors and institutions use this strategy to provide monthly or quarterly returns (cash flow). It can be a lucrative strategy, and you can get stocks at prices that you thought were a good price anyway.
Remember that you must have the money ready, hence "cash-secured puts". You have in fact imposed on you the OBLIGATION to buy these shares as the issuer of the option contract. If the share price reaches the "strike price" within your agreed time horizon (expiry date), you must therefore buy the share from the investor on the other side of the trade.