The Cash-Secured Put: An Alternative to Covered Calls

02/22/2010 10:58 am EST

Focus: OPTIONS

Last week, I played with a cash-secured put idea in Whole Foods (WFMI). Since the company reported blowout earnings on February 17 and the stock has been up more than 12.5% at its highs, the February 29 put we sold is set to expire worthless. This makes our trade (where we sold that put for $1.10) achieve its maximum return.

Below is a snapshot of the trade’s risk/reward dynamics.


Click to Enlarge

The cash-secured put is a strategy that many investors like to use for stocks they want to buy at a discount. I say “at a discount” because the strategy usually involves selling an out-of-the-money put. If the stock does move lower through that strike by expiration, you will face assignment of the short put and end up buying the shares at the strike price—but you also have the additional income you received for selling the put.

When we looked at the WFMI February 29 put, the stock was trading around $29.60. Selling the put for $1.10 gave us an effective cost to buy the stock of $27.90 if it went below $29 by expiration and we were assigned. For the risk of this position, our broker required that we have sufficient funds in our account to buy the stock, in this case 100 shares x $29.00 – $1.10 = $2,790. This is why the strategy is called “cash-secured.”

In this trade, we didn’t get to buy the stock because it will likely stay above the $29 level through February expiration. But we did generate income off a name we were fond of. That’s why this strategy is a nice alternative to buying stock and selling covered calls, even though the two strategies have identical risk/reward dynamics.

To practice building strategies like cash-secured puts and dozens of other option trade ideas, be sure to try the free virtual tools at your broker or at any of the options exchanges. You can even implement the trade strategy in a practice account to simulate its dynamics in real time and make sure you are comfortable with it before you deploy real money. It’s the perfect “test drive” for all your investment ideas.

By Kevin Cook, contributor, TheOptionsInsider.com

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