Updated October 4th, 2018
Originally by Eli Inkrot, updated by Nick McCullum
The end goal of many dividend growth investors it to generate enough passive income to cover their living expenses.
There are two basic solutions to reaching this goal faster:
- caHave a larger investment portfolio
- Generate more yield from your existing portfolio
In general, the only changes that you can make today is to generate more yield. High yield dividend stocks are useful for this, but so are dividend-focused stock option trading strategies.
In this article, we’ll introduce the cash secured put income generation strategy, which is one options strategy that you can use to boost the passive income generated by your investment portfolio.
Table of Contents
This guide is comprehensive and we recommend reading it in its entirety. With that said, you can skip to individual components of the article using the table of contents below:
- Video: How To Boost Your Dividend Income Using Cash Secured Puts
- What is the Cash Secured Put Income Generation Strategy?
- Benefits of Cash Secured Puts
- Downsides to Cash Secured Puts
- Cash Secured Put Example #1: Johnson & Johnson (JNJ)
- Cash Secured Put Example #2: The Coca-Cola Company (KO)
- Cash Secured Put Example #3: Berkshire Hathaway (BRK.B)
Video: How To Boost Your Dividend Income Using Cash Secured Puts
For investors who prefer to learn about new strategies through videos, we have created the following video companion to this guide on the cash secured put income generation strategy:
What Is A Cash Secured Put Income Generation Strategy?
To understand what a cash secured put options strategy is, you need to have a fundamental understanding of stock options. Here’s the formal definition of a stock option.
“A stock option is a contract between two parties in which the stock option buyer purchases the right (but not the obligation) to buy/sell 100 shares of an underlying stock at a predetermined price (called the strike price) from/to the option seller within a fixed period of time.”
If the contract allows the optionholder to buy the security, it is a call option.
If the contract allows the optionholder to sell the security, it is a put option.
Each stock option corresponds to 100 shares of the associated security, which is called the “underlying.” This is a very important concept to understand, and makes the cash secured put strategy unsuitable for investors that have only small amounts of capital to invest in the stock market.
In a cash secured put options strategy, you sell a put option for a security that you would like to perhaps purchase, but at a lower price than it is currently trading at. This allows you to receive the option premium upfront in exchange for the obligation (if the option is exercised) to purchase the security at a lower price point.
An image is helpful in understanding the payoff profile of a cash secured put options strategy:
Here, the underlying’s stock price is on the horizontal axis and the strategy’s payoff profile is on the vertical axis.
As you can see, the upside of the strategy is equal to the option premium received, less any applicable commissions.
As the price of the underlying stock declines past the strike price of the option, the strategy becomes less profitable and, eventually, the investor participating in the cash secured put options strategy loses money.
As with any investment strategy, the cash secured put income generation strategy has pros and cons. We will dive into these – beginning with the benefits – before concluding this guide with several detailed examples.
Benefits of The Cash Secured Put Income Generation Strategy
Put Option Benefit #1 = You Get Paid
When you sell cash secured puts, you get paid the option premium upfront. Depending on the security and the price at which you’re willing to buy, this cash flow can be significant. Sometimes the option premiums generated by this strategy can actually dwarf the dividend income generated by the stock itself.
Put Option Benefit #2 = You Can Reinvest Right Away
Cash secured puts allow for immediate reinvestment. 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
When a cash secured put strategy is implemented, there are hundreds of available strike prices and expiration dates. If you would be happy to own a certain stock at $50, then you can structure that agreement and still get paid for doing so. If you would only be happy to own a stock at $45, then you can make that agreement instead, although you will receive a lower option premium in exchange for a smaller purchase price. Using put options gives you great flexibility in that you’re not simply taking prices that are available on the open market.
Put Option Benefit #4 = Allows You To Own Lower Yielding Securities
You might think that say Visa (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.
This concludes our discussion of the benefits to the cash secured put income generation strategy. Next, let’s move on to some potential downsides.
Downsides of the Cash Secured Put Income Generation Strategy
Put Option Downside #1 = You Have To Work In Round Lots
Options trade in “round lots” of 100 shares. Usually share price does not matter (in dollar terms, not in value terms), but in this situation it certainly does because of the round lot requirement. This can limit the feasibility of allocating capital in this manner.
As an example, trading options on Owens & Minor (OMI) – which has a current stock price of around $17 – is feasible for most investors. Conversely, trading options on Amazon – which has a current stock price of around $2,000 – is out of the realm for all but the most affluent.
Put Option Downside #2 = You May Never Own Shares
The cash secured put income generation strategy is not suitable for investors that need to eventually own shares of the underlying company. 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 do not 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 option buyer’s (the seller of the underlying stock) discretion.
Put Option Downside #3 = You Don’t Collect The Dividends While You Wait
With a covered call income generation strategy, 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 the cash secured put income generation strategy, the option does not have to be exercised. With that said, every time your short options expire, you will need to re-initiate the strategy by selling more cash secured puts. This makes the strategy more time-intensive than long-term ownership of the underlying securities.
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.
Cash Secured Put Example #1: Johnson & Johnson (JNJ)
The first cash secured put options strategy that we’ll explore is Johnson & Johnson (JNJ), a well-known healthcare conglomerate.
When you look up stock options in your broker’s trading interface, you will usually be presented with what is called an “options chain.” An options chain shows the different strike prices for call and put options at a certain expiration date. For example, here is the options chain for Johnson & Johnson that expire on July 27th, 2018 using the Interactive Brokers trading interface.
You can see Johnson & Johnson’s ticker in the top left. Nearby, you can see that I have selected the July 27th, 2018 expiration date. With this broker, hovering over particular strike prices will show you the standard deviation difference between the security’s current price and its market price. In Johnson & Johnson’s case, the $116 put options are exactly 1 standard deviation below its current price, making them a prime candidate for our cash secured put options strategy.
We have now determined which put option we want to sell. The next step is determining how much cash is required to secure the transaction. This is calculated by multiplying the strike price of the option by the number of shares that are associated with the option, which is always 100. In this case, an investor needs to leave $11,600 in their brokerage account in case the options need to be exercised at the time of their expiration.
Next, we need to determine the price that we should offer to the markets. There are two nuances that make trading options different than trading common stocks.
The first is the relative illiquidity of stock options.
As you can see by examining Johnson & Johnson’s option chain, there is a real bid-ask spread for each of the strike prices in the options chain. As an option seller (which is what we’re doing in a cash secured put strategy), you should always budget to receive the “bid” price.
The second unique aspect to pricing options is that even though options contracts correspond to 100 shares of stock, the quoted price is per share. Accordingly, multiply the quoted price by 100 to calculate your actual proceeds from selling 1 cash secured put.
In Johnson & Johnson’s case, this corresponds to $79 per option contract, or $0.79 per share.
Lastly, we’ll want to calculate the additional yield on the collateral we’ve put up against these cash secured puts.
We can calculate the additional income from the cash secured put strategy using the following formula:
The formula has two factors. The first is option premium divided by the trade’s cash collateral. This factor gives you how much absolute return you received expressed as a percentage of stock price.
The second is 365 divided by days until expiration, which turns your absolute return into an annualized return figure. This is important because almost all rates of return in finance are expressed on an annualized basis, so this improves the comparability of the cash secured put options strategy.
In the case of Johnson & Johnson, here’s what the actual math works out to:
The investor received a $79 of option premium while the stock in exchange for posting collateral of $11,600. The option had 45 days until expiration. This provides an annualized return of 5.5%.
The next two examples will cover other well-known stocks – Coca-Cola (KO) and Berkshire Hathaway (BRK.B) – while sparing some of the detail of this first example.
Cash Secured Put Example #2: The Coca-Cola Company (KO)
You can see Coca-Cola’s options chain here:
As before, the company’s ticker is shown in the top left and the expiration date of the options we are looking at is shown just below that. In this case, the $42 strike price is just over 1 standard deviation below its current price. These options have a bid of $0.22/share, or $22 per option contract.
Here’s how we would calculate the additional yield that we can generate from cash waiting to buy Coca-Cola by selling these cash secured puts:
The $42 options dated July 27th are selling for $22 per contract. $4200 of collateral would need to be posted to secure this trade. This cash secured put provides an annualized yield of 4.2%.
Cash Secured Put Example #3: Berkshire Hathaway (BRK.B)
The next example of a cash secured put strategy that we’re going to explore is for Berkshire Hathaway’s class B shares.
This example is unique because Berkshire Hathaway is the first company in this article that does not pay a dividend. Because of this, Berkshire Hathaway is a great example of how you can generate passive income from companies that do not currently pay dividends.
First, we’ll consider Berkshire Hathaway’s options chain. You can see the company’s options chain for July 27th here:
In this case, it turns out that Berkshire Hathaway’s $185 put options are 1 standard deviation below its current market price. You will note that the options are selling for $0.91/per share right now, or $91 per contract.
Here’s how we can calculate the passive income available this cash secured put opportunity:
The $185 options dated July 27th are selling for $91 per contract. $18,500 of collateral would need to be posted to secure this trade. This cash secured put provides an annualized yield of 4.0%.
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 legwork or apprehension about never owning a security. If you’re going to be kicking yourself if shares rise higher, this is something that you should think about before initiating a cash secured put income generation strategy. The psychological barriers are every bit as real as the structural ones. The point is to figure out what may be right for you.
In any case, the cash secured put options strategy is suitable for sophisticated investors who would like to increase the passive income generated by their investment portfolios. If you have any questions about the implementation of this strategy, please feel free to contact us via email at firstname.lastname@example.org.