Saturday, June 28, 2008

Hedging Stock Investments Using Low-Risk Options Strategies - Cash-Secured Put Selling

Please note that this example is for educational purposes and uses a historical trade from March 2007

Another way to play the income aspect of the Covered Call is through a strategy known as Cash-Secured Put Selling, which involves selling a put option, keeping the premium, and—if the option is exercised by the buyer—purchasing the 100 shares per contract. This might sound risky, but the idea is for the investor to keep enough cash in the account to purchase the shares should he receive an exercised notice. This strategy is ideal if used on a stock that an investor would not mind owning in their portfolio, should they receive an exercised notice.

In figure 2 below, the investor is taking a hypothetical trade in Cisco Systems (CSCO) on March 22, 2007. The investor sells the July 2007 $27.50 Put option at $1.42, which results in a cash premium received of $142 (representing a 5.44% return from the total cash requirements of $2,608). The trade is very similar to the Covered Call strategy and has the same Profit/Loss chart layout. The Cash-Secured Put Selling strategy is more appropriate on stocks that do not pay large dividends because, with it, the investor does not have the incentive to hold the shares to receive the dividend. Another nice feature of this strategy is the cash that the investor must keep on hand to secure the short put option can be invested in 90-Day T-Bills, which would provide the investor with some additional income. Another way an investor could utilize this approach is if he wanted to buy a stock at a lower price than what the stock is currently trading at. To do so the investor could decide to sell an in-the-money put option (which will most likely lead to the option being exercised). Therefore, instead of buying the stock outright, the investor would receive the premium today and as the option approaches expiration the investor would be required to purchase the underlying shares when the short option is exercised by the counter-party.

Cash Secured Put

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