Covered Put vs Cash-Secured Put: Which Is Better?

Covered Put vs Cash-Secured Put: Investing in the stock market is a popular way to build long-term wealth. But not everyone is interested in waiting for share values to increase over many years. Some prefer the excitement of buying and selling the same shares over the course of a few hours, a few days, or a few weeks.

These traders analyze historical stock price data to find patterns, then attempt to predict what the stock price will do next. When they time their trades just right, they have a chance to generate significant returns – practically overnight.

The trouble with this type of trading is that it requires access to capital. For many short-term investors, it’s not always possible to act on promising trends because the cash just isn’t there.

Fortunately, there is an alternative: options contracts. Buying options offers an opportunity to secure a position in an encouraging trend without a large infusion of capital. Better yet, collecting premiums from selling options can be quite profitable.

How Many Stock Options Strategies Are There?

There are literally hundreds of distinct options strategies. The choice of which to use in a specific situation comes down to the purpose of the options contract.

Is the goal to gain access to a particular security at a target price? Is the plan to generate profit through contract sales? Or is the objective to mitigate the risk of another trade?

In some cases, the maximum potential loss is the premium paid for the contract. In others, the maximum potential loss is virtually unlimited.

Every options trading strategy involves one or both of the two basic types of stock options:

  • Call Options – The owner of the option has the right (but not the obligation) to buy the underlying stock at the listed price (strike price) by a predetermined date (the expiration date).

  • Put Options – The owner of the option has the right (but not the obligation) to sell the underlying stock at the strike price by the expiration date.

Those who sell call options and put options charge a premium for the contract, which they keep whether or not the buyers/owners of the options contracts exercise their right to buy or sell the underlying stock according to the terms of the contract.

Selling options contracts tends to be most profitable when the underlying stock price doesn’t go above the strike price of a call option or below the strike price of a put option by the expiration date. In these situations, there is no reason for the contract owner to exercise the option. The option contract expires worthless, leaving the seller of the contract with profit from the premium.

However, options sellers sometimes bet wrong when they write contracts. They miscalculate whether or how much the price of the underlying security will change. In some cases, they misread market signals, while in others, an unexpected event disrupts a pattern.

When options contracts are exercised, the options strategy in use will determine exactly how severe the losses are for the trader who sold the option. For example, selling a covered put vs cash-secured put, also known as a cash-covered put, carries entirely different risks.

What Is A Covered Put?

The covered put strategy involves two separate trades that work together to reduce risk.

First, the trader completes a short sale of a particular sock, then the trader writes a put option for the same stock and collects a premium.

If the price of the underlying stock goes down as expected, the trader can profit from the short sale. However, potential profits are limited to the difference between the short sale price and the strike price on the put.

Consider this example:

  • Trader shorts 1,000 shares of ABC stock at $72 per share

  • Trader sells 10 ABC put options with a strike price of $70, a June expiration date, and a $2 premium

The trader will break even at $74 per share because of the $2 premium. Profits begin to grow if the share price continues to fall. However, because of the put option, the maximum profit is $4,000, no matter how much the stock price drops.

On the other hand, if the stock price goes above $74 per share, the trader will begin to incur losses. In theory, the total losses aren’t capped, because the stock price could increase to any value. Whatever the total loss turns out to be, it is reduced by $2,000 as a result of the premium collected from the sale of put options.

In most cases, there is little risk of a sudden, dramatic rise in stock prices, but the scenario isn’t unprecedented. In January 2021, GameStop stock abruptly went from less than $20 per share to almost $500 per share. Investors in short positions on GameStop stock experienced extraordinary losses.

When the CEO of online brokerage firm Robinhood testified before Congress about the sudden rise in GameStop stock, he said this particular situation was a 1 in 3.5 million event. But it did happen, which should give sellers of covered puts reason to carefully consider the strategy before moving forward.

The covered put strategy is best employed when traders believe a stock’s price will drop – but not too much. The target price is somewhere between the short sale price and the put option’s strike price. If the stock goes lower than the put option’s strike price, then a short sale alone would be more profitable than a covered put.

What Is A Cash-Secured Put?

A cash-secured or cash-covered put takes a different approach to selling puts. Unlike a covered put, traders don’t short the underlying security when selling the put option. Instead, they set aside the cash necessary to purchase the underlying stock at the strike price of the put option.

The goal is to acquire the desired stock at a lower price than the price at the time the put option is sold. Along the way, traders selling cash-secured put options make a little extra from the contract premium.

Consider this strategy as an alternative to waiting for a stock price to come down before making a purchase. It is common for investors to set up limit orders to buy stock when it hits a desired price.

Cash-secured put options are intended to achieve the same objective – when the stock price goes down, it is likely the put will be exercised.

The trader who sold the cash-covered put can use the cash set aside for this purpose to purchase shares from the holder of the put option at the lower price. If the stock never hits the strike price or the put option isn’t exercised, the seller still profits from the premium payment.

As with any options strategy, the cash-secured put carries some risk. The first is that the seller might fail to set aside enough cash to buy the stocks as required. The second is that shares of the underlying stock might fall to the desired level – and then they could keep going down. Traders must still purchase the stock at the strike price listed in the put option contract, even if shares become worthless.

Consider Coinbase, the cryptocurrency exchange that traded above $200 in February 2022. In the 12 months that followed, several shocking failures in the cryptocurrency industry pushed Coinbase’s stock price down. As of late January 2023, Coinbase’s stock traded under $60 per share. Again, this isn’t a typical scenario, but it’s not unheard of.

Covered Put vs. Cash-Secured Put

The bottom line when discussing the covered put vs cash-secured put is that even though the strategies sound similar, they are used for different purposes and they carry different levels of risk.

A covered put is when an option is written against a short position as part of a larger short selling strategy. It has limited upside potential and a lot of risk, so it is best used by experienced investors.

A cash-secured put is intended to generate a bit of profit from premiums while acquiring stock at a lower price. However, it carries its own set of risks. Traders who are unwilling or unable to take the risk that the underlying stock price will drop more than expected should simply buy the desired shares outright.

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