Case study: using cash-secured puts to acquire stocks at a discount and generate income

Introduction

In the world of investing, finding ways to enhance portfolio returns while managing risk is a constant challenge. One strategy that has proven effective for many investors is the use of cash-secured puts. Cash-secured puts involve selling put options on a stock while holding enough cash to buy the stock if the option is exercised. This approach not only provides a steady stream of additional income but also offers the opportunity to purchase stocks at a lower price. For investors looking for a balanced approach to generating income and managing risk, cash-secured puts can be a valuable tool.

Important note

The strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

Background

Jane, a seasoned investor, has $45,000 in cash and is interested in acquiring shares of Fictitious Inc., an imaginary company created for the purpose of this case study. Fictitious Inc. is currently trading at $50 per share. Jane has been investing for several years and has built a diversified portfolio. While she is confident in the long-term potential of Fictitious Inc., she is looking for ways to generate additional income from her cash holdings. Jane believes that by using strategic options, she can enhance the yield of her portfolio without taking on excessive risk. She aims to achieve a higher return on her investment while potentially acquiring shares at a discounted price.

Challenge

Jane seeks additional income but is cautious about committing her cash holdings without a strategic plan. Although she believes in the long-term growth prospects of Fictitious Inc., she is aware that the stock market can be unpredictable in the short term. To address this, Jane is looking for a strategy that allows her to earn extra income while maintaining the flexibility to buy Fictitious Inc. at a lower price if the opportunity arises. She wants to make sure that any strategy she employs does not compromise her long-term investment goals or expose her to undue risk.

Solution: Using Cash-Secured Puts

Jane sells 10 put option contracts on Fictitious Inc. with a strike price of $45, expiring in 30 days. She receives a premium of $2 per share, totaling $2,000 (since each option contract covers 100 shares and she sold 10 contracts).

Financial Comparison

• Current Holdings: $45,000 in cash.
• Put Option Sale: Jane receives $2,000 in premiums.

Outcome and Analysis

• If Fictitious Inc. trades at $50 at expiration: Jane retains her cash and the $2,000 premium. Her effective income is $2,000, with no obligation to buy the stock.

• If Fictitious Inc. trades at $45 at expiration: Jane buys 1,000 shares of Fictitious Inc. at $45 each, costing $45,000. She keeps the $2,000 premium, effectively reducing her purchase price to $43 per share ($45 - $2).

• If Fictitious Inc. trades below $45 at expiration: Jane still buys 1,000 shares at $45 each, costing $45,000. With the $2,000 premium, her effective purchase price remains $43 per share. If the stock drops significantly, she holds the shares for long-term appreciation.

ROI and Yield

• Maximum Profit: $2,000 (the premium received).
• Maximum Risk: $43,000 (if Fictitious Inc. falls to zero, Jane's effective purchase price is $43 per share x 1,000 shares).
• Break-Even Point: $43 per share (strike price of $45 minus $2 premium received).
• Annualized Return: The $2,000 premium for 30 days translates to an annualized yield of approximately 5.3%. This is calculated as ($2,000 / $45,000) * 12 months.
• Enhanced Yield: Jane increases her portfolio's yield by approximately 0.44% monthly or 5.3% annually. This additional yield is a significant boost to her overall returns, showing how cash-secured puts can generate extra income.

Conclusion

By integrating cash-secured puts, Jane not only generates additional income but also positions herself to buy stocks at a lower price. This strategy enhances portfolio performance by providing a steady income stream and the potential to acquire shares at a discount. However, it does require a willingness to purchase the stock if the price falls. This balanced approach makes cash-secured puts a versatile tool for investors seeking to optimize their returns while managing risk.