Selling covered puts (or cash secured puts) is a popular strategy among investors looking to generate income with stocks they are willing to own. While it requires understanding some financial nuances, the strategy can provide regular income, help investors acquire shares at a lower price, and, if managed carefully, be a solid tool in a broader income portfolio. This guide walks you through the benefits, risks, and key strategies for successfully selling covered puts.
What is Selling Covered Puts?
Covered puts allow investors to generate income by selling the right to buy a security at a lower price than its current market value. For example, if you sell a put on Stock A with a strike price of $90 (when the stock currently trades at $100), you collect a premium in exchange for agreeing to buy the stock if it drops to $90. This income-generating tactic is ideal for investors with a neutral or slightly bullish outlook on a stock they would be comfortable owning.
Key Benefits of Selling Covered Puts
Income Generation
One of the main advantages of selling covered puts is the immediate income generated from premiums. This income helps offset some of the risks associated with owning the stock. Investors who choose stocks they wish to own can earn income on the security even if they never end up purchasing the shares.
Lower Entry Price
By selling puts, investors set a “target price” they’re willing to pay. If the stock price drops to this level, they’re assigned the stock at a discount. This approach can be especially useful if the investor has a long-term outlook for the stock, as the put premium lowers the overall purchase cost, creating a lower entry point than buying the stock outright.
Reduced Cost Basis
Each premium received further reduces the total cost basis for the stock. Let’s say you sell puts on a stock several times before finally being assigned shares. Each premium collected has effectively reduced your final purchase cost, making it easier to achieve profitability, even if the stock’s performance is only slightly bullish.
Covered Put Example
Executing a covered put (or cash secured) strategy involves selecting a suitable strike price and expiration date. Here’s how to set up a trade:
Selecting Strike Prices and Expiration Dates
Strike prices represent the “target price” where you’re willing to buy the stock if assigned. Here are common types of strike prices used:
- In-the-Money (ITM): These puts have strike prices above the stock’s current price and offer the highest premium but also the highest risk.
- At-the-Money (ATM): Strike prices are close to the current stock price, balancing income potential and risk.
- Out-of-the-Money (OTM): With a strike price below the current stock price, these options yield lower premiums but carry a lower probability of being assigned, making them suitable for more conservative investors.
When choosing an expiration date, remember that options with shorter timeframes have higher rates of time decay, potentially increasing annualized returns. However, longer expiration dates offer more income certainty.
Example
Imagine an investor interested in purchasing Stock XYZ, which currently trades at $100. They could sell a put with a $95 strike price and a premium of $3. If the stock’s price falls to $95, they buy it at the strike price with a net cost of $92 ($95 – $3 premium). If the stock remains above $95, the put expires worthless, and they retain the premium as income.
Adjusting and Managing a Covered Put Position
Sometimes, adjustments are necessary to manage risk or optimize returns. Here are a few techniques to consider:
Rolling Options
Rolling involves closing an existing put and opening a new one with a different expiration date or strike price. This can be beneficial if market conditions change. For example, if the stock’s price increases, rolling the put to a higher strike or later expiration can increase premiums. Conversely, if the stock drops, rolling down to a lower strike can help avoid assignment.
Monitoring Implied Volatility (IV)
High implied volatility (IV) often means higher option premiums, which can be advantageous for covered puts. However, as IV falls, the option’s value may decrease, which is favorable for the put seller. By monitoring IV, investors can adjust their strike prices or expiration dates to capture higher premiums when volatility is expected to remain elevated.
Comparison with Other Income Strategies
Covered puts aren’t the only strategy available for generating income. Here’s how they compare with a few alternatives:
- Covered Calls– Selling covered calls involves selling a call option on stock you already own. This strategy limits upside potential but can be ideal for a mildly bullish outlook.
- Selling Naked Puts – Unlike covered or cash-secured puts, naked puts don’t have collateral, increasing potential losses but allowing for higher premium income.
Each strategy has its benefits and ideal use cases. Covered puts can be advantageous if you want income from stocks you’re interested in acquiring while retaining flexibility through adjustments.
Covered Puts Best Practices and Tips
To maximize the effectiveness of covered puts, consider the below best practices.
| Best Practices / Tips | Description |
|---|---|
| Set Clear Risk Limits | Decide on risk levels in advance, such as a percentage of losses you’re willing to accept or predetermined price targets. Setting stop-loss levels can help limit downside risk, especially in volatile markets. |
| Review Market Conditions Regularly | Stay aware of current market conditions and news affecting the stock. Changes in volatility, earnings reports, and other factors can impact the value of options and influence your strike price and expiration choices. |
| Diversify Your Options Portfolio | Avoid putting all your capital into one position. Diversifying across multiple options strategies can help spread risk and improve income stability. |
| Manage Emotions and Biases | Trading options involves risk, and it’s important to stay objective. Avoid holding on to a trade if it no longer aligns with your outlook and use systematic criteria for decisions rather than emotional responses. |
Warren Buffet Selling Cash Covered Puts?
Warren Buffett has used cash-covered puts effectively, particularly on companies he is interested in owning, such as Coca-Cola. In 1993, Buffett sold 50,000 put options on Coca-Cola at a $35 strike price when the stock was trading around $39. This move earned him $7.5 million in premiums, which he kept regardless of whether he ended up purchasing the stock. This strategy aligned with Buffett’s valuation criteria—he wanted to own Coca-Cola but at a lower price. If the stock had fallen to $35 or below, he would have bought it at a net cost of $33.50 (factoring in the $1.50 premium received)
Buffett’s approach with options extends beyond individual stocks. During the 2008 financial crisis, he sold puts on global indexes, taking advantage of heightened volatility. He collected nearly $5 billion in premiums by betting that the markets would eventually recover. Buffett often reserves this strategy for periods of high implied volatility, enabling him to collect large premiums upfront. By leveraging Berkshire Hathaway’s substantial cash reserves, he can cover potential obligations without overextending, a luxury that amplifies the profitability and feasibility of such trades
Conclusion
Selling covered puts is an effective way to generate income while setting a target price for owning a stock. By carefully selecting strike prices, monitoring implied volatility, and using adjustments like rolling, investors can optimize returns while managing risks. Though not without its drawbacks, this strategy can provide a steady income stream, lower cost basis, and help investors acquire desired stocks at a discount. As with any investment, covered puts require careful planning, disciplined management, and an understanding of market conditions.
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