A foray into the world of options trading could give some investors a way to make money without deploying tons of cash in securities – but they should make sure they understand the risks first. The opportunity lies in cash-secured puts, a strategy in which investors sell put options – an instrument that gives the holder the right to sell an asset at a specified price – for securities that they think will go up over a set time, for a premium. Investors then set aside the cash they’d need to buy the underlying security – a single stock or exchange traded fund – if the option is exercised, in the hope that it won’t be called, and they get to keep the premium. “You’re essentially riding out that put contract, betting that the security is going to go up,” said Ashton Lawrence, a financial advisor at Goldfinch Wealth Management in Greenville, South Carolina. “Someone is taking the other side of that, saying it’s going to go down.” A few important caveats While the strategy may sound simple – basically, it’s betting on a stock going up – the process is a bit more complicated. First, such contracts require investors to promise to purchase 100 shares of a stock or ETF. Say a stock is currently trading at $100 per share and you think it will either stay relatively flat or increase. If you sold a put option on that stock at $90 per share that expires in three months, you’d have to set aside $9,000 to cover the position. When you sold the put, you might get a premium of $500 that is yours regardless of what happens to the underlying security. If the stock is more than $90 in three months, the contract will expire worthless, and you don’t have to purchase the 100 shares. This means you get to keep your $9,000 and gain an additional $500 in premium from the contract – an almost 6% return. “It’s an income strategy that you’ve removed the risk of having to go buy the stock, although you have the money,” said Douglas Boneparth, a certified financial planner and president of Bone Fide Wealth in New York. But you can also end up getting hit. If the stock you’ve sold a put on falls below $90, you will have to purchase the security at the strike price you agreed upon, at the end of three months. That means that even if the security goes to zero, you are obligated to pay $9,000 to buy the 100-share position. While you get to keep the $500 premium, you’ve spent $9,000 on a stock that’s fallen in value. “That’s the big risk,” said Lawrence. Of course, most stocks wouldn’t necessarily plunge and instead might just fall slightly below the strike price, still triggering a 100-share purchase. There is also a silver lining: You’ve snatched up shares at a discount — which is why it’s important to base this strategy on shares you would actually like to buy. Picking puts Because you may be on the hook for a sizable position in the security you sell puts on, it makes sense to choose the asset carefully. Lawrence suggests picking stocks you’d like to hold, or already hold, because you think they’re going to gain. Then, if you must purchase the position, it’s hopefully not a huge hit. “The thing I want to stress with people is to still view this as part of your overall portfolio,” he said. That means considering how potentially purchasing 100 shares of the security you choose will change your allocations. If it will significantly over-allocate you in one area or one stock, it’s worth noting and planning to diversify. Because of the complexity of this trade, Lawrence suggests working with a financial advisor or money manager who is an expert on trading options instead of doing it yourself. Boneparth added that for most investors, options trading might not be a great idea because it might not add value and could instead be a distraction. “For most investors, this probably isn’t something they’re going to be doing because investing and being disciplined around long-term investing is hard enough as it is,” he said. “When you add options strategies, it can get away from practicality.”
