A Look At The Outcomes
There are two basic things that could happen once you make that agreement:
– The option is exercised
– The option is not exercised
If the share price of Deere & Company (NYSE:DE) remains above $75 it’s very unlikely that the put would be exercised (Why sell to you at $75, when the option buyer could sell for higher price on the market?).
In this scenario, the option expires worthless. You keep your $525 option premium and your $7,500 is “released” or available once again to be deployed as you see fit.
The upside in this scenario is that you received an immediate 7% yield based on the cash you set aside. The negative bit is that you don’t yet have shares in a company that you’d like to own.
If the share price of Deere & Co. goes below $75, it’s likely that the put would be exercised. In this case you would trade your $7,500 for 100 shares of Deere. You still keep your option premium of $525, but your total return would be based on what happens with the share price.
The upside is that you got to buy shares at a lower price. Better yet, you got paid for doing so, so your cost basis would now be below $70. The downside is that your return could still be negative (say if shares went to $65).
Yet I would contend that this isn’t especially troublesome. If you were planning on buying shares anyway, selling the put option simply allowed you to do so at a lower price.
Let’s summarize the information with the basic benefits and potential downsides of using a cash-secured puts. We’ll start with the good stuff.
Put Option Benefit #1 = You Get Paid
Unlike a limit order, with selling puts you get paid to express your sentiment. Depending on the security and the price at which you’re willing to buy, this cash flow can be significant. In the above scenario, if you agreed to buy shares of Deere & Co. at a 6% lower price you could collect a 7% yield in under 10 months.
Put Option Benefit #2 = You Can Reinvest Right Away
Not only can the cash flow be significant, but it also happens immediately. You make an agreement now and a few seconds later that capital is available to you to be deployed. There’s a time value of money aspect here that can make option income more attractive than waiting on other sources of cash flow.
Put Option Benefit #3 = You’re Able To Dictate A Lower Price
I used a price of $75 in the above example, but it follows that there are hundreds of available strike prices and expiration dates. If you feel that $50 would be a great price, you can make that agreement and still get paid for doing so. Granted the option premium is going to be lower in this scenario, so it’s paramount to think about the opportunity costs of having to set aside those funds. Still, using a put option can give you great flexibility in that you’re not simply taking what the market happens to offering.
Put Option Benefit #4 = Allows You To Own Lower Yielding Securities
You might think that say Visa Inc (NYSE:V) is an excellent company, but have never really given it much attention due to its low dividend yield. By selling a cash-secured put you could get paid for agreeing to a lower price and thus increase your cash flow stream. Options are aptly named. They can open up possibilities that you may not have previously considered.
That does it for the positives, now let’s move on to some potential downsides.
