Put Option Downside #1 = You Have To Work In Round Lots
Options trade in “round lots” of 100 shares. So if you have say $5,500 to deploy you couldn’t use the cash-secured put option for Deere that was described above.
Usually share price does not matter (in dollar terms, not in value terms), but in this situation it certainly does. This requirement can limit the feasibility of allocating capital in this manner.
Put Option Downside #2 = You May Never Own Shares
If the share price stays higher, you may never own shares. Even if the price momentarily moves down past your agreement price this does not mean that it will be automatically triggered.
Incidentally, this is one advantage of a limit order. Although you don’t get paid for a limit order, it will transact if shares are trading at or below your set price. With a put option it’s at the buyer’s discretion.
Using the above example, shares may go to $73 in the next month. With a limit order you would buy shares. With the put option it could be exercised, but there isn’t a requirement that it must. Should shares go higher after that the put option may never be exercised. This is a true risk and something that you keep in the back of your mind. It’s also why it’s so important to be content with either side of the agreement.
Put Option Downside #3 = You Don’t Collect The Dividends While You Wait
With a covered call you still receive the dividend payments, as you still own the underlying security. With a cash-secured put you do not yet own the security and thus you do not collect the dividend payments.
You’re compensated for this with the upfront premium, but it remains that this will be your only cash flow until the option is exercised or it expires.
Put Option Downside #4 = You Might Have To Redeploy The Capital
If you’re a “set it and forget it” type investor, a simple buy and hold strategy is apt to be more attractive to you.
With selling puts the option does not have to be exercised. So in keeping with the example above you might wake up in January of 2017 with an “extra” $7,500 to allocate once more. Personally this is what I enjoy about the investing world, but it follows that this takes more time, thought and preparation.
Put Option Downside #5 = There Are Separate Tax Implications To Think About
If the put option is not exercised, the option premium can be taxed as ordinary (short-term) income.
If the option is exercised, the option premium becomes part of your cost basis and future tax considerations depend on how long you hold the underlying security. There’s an added layer of complexity involved that is not present with buying, holding and collecting qualified dividend payments.
Follow Deere & Co (NYSE:DE)
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Final Thoughts
Selling a cash-secured put, in its simplest form, is getting paid to agree to buy at a price that you would be happy with. You might use this strategy to enhance your cash flow or to own a security at a cost that you deem is fair. If you’re going to work with options, you want to make sure that you’d be content with either side of the agreement.
You might be turned off from selling put options due to the added complexity, extra leg work or apprehension about never owning a security. If you’re going to be kicking yourself if shares of Deere & Company (NYSE:DE) go to $100 and you “only” received a 7% return, this is something that you should think about. The psychological barriers are every bit as real as the structural ones. The point is to figure out what may be right for you.
Personally before buying any security I like to see what’s available with the put options out there. Granted this doesn’t mean that I use a put option all the time, or even the majority of the time.Things come up like having to work in round lots, or not liking the terms offered or any number of additional reasons. The idea is to at least be aware of the possibilities to see if anything interesting is being offered.
Disclosure: This article is originally published on Sure Dividend by Eli Inkrot.
