Investors that have the goal of generating income from their portfolio generally have two methods at their disposal to do so. They can simply increase the size of their portfolio and thereby boost the number of dollars that are produced by the portfolio’s average yield. But “have more money” is rarely an option.
Alternatively, investors can boost the average yield of the portfolio in order to generate more income from the portfolio on a relative basis. Investors can do this with a variety of instruments including high-yield debt, preferred stock, high-yield dividend stocks, and the focus of this article, cash-secured puts. We’ll take a look at how the strategy works and how investors can employ it with a real-world example in order to boost their average portfolio yield, thereby generating higher levels of income.
How Cash-Secured Puts Work
Cash-secured puts are a way for investors to agree to buy a stock at a later date for a set price in exchange for what is called option premium. In other words, when an investor sells a put option – which is the right to sell a stock at a defined price on or before a defined date – the investor is essentially agreeing to buy that stock at the prescribed date and price. This generates option premium, which is income for the investor selling the put. One of the reasons investors sell put options is to generate income on a stock the investor is interested in owning anyway. We’ll take a look at how it works with an example on a high-yield dividend investor favorite, AT&T (T).
A Real-World Example of How to Sell Cash-Secured Puts
AT&T is a telecommunications giant that recently purchased Time Warner in order to boost its content library and diversify away from wireless service. For a primer on AT&T’s business, please see here. The stock offers investors a 5.9% dividend yield, making AT&T one of the highest-yielding common stocks in the mega-cap space, and thus making it an income investor favorite. AT&T’s dividend yield is certainly quite high and the payout is safe, but investors can generate even more income than they would by just owning the stock. That is where cash-secured puts would come into play.
This is how a cash-secured put works: an investor sells the put option, agreeing to buy the underlying stock at a specified time and price, called the “expiration date” and “strike price”, respectively. The profit for the investor selling the put looks like this:
Profit is capped at the total amount of the option premium received by the investor at the time of the sale and in this example, would be $2. Profit declines down to the point where the investor is exposed to theoretically unlimited downside risk as the underlying stock price declines, similarly to if the investor had simply bought the stock. Selling a put offers a variety of advantages over simply buying a stock, including being able to dictate the price one is willing to pay – often below the current price – generating income and reducing risk. The investor is exposed to potential losses if the share price falls but gets to keep the premium generated by the put sale should the share price rise.
In a real-world example, we can see AT&T’s option chain for the December 21, 2018 strike price. This chain shows both calls and puts, and we are interested in the right side of the chain, which is the put side.
The yellow strike prices are “in-the-money”, meaning the share price is already under the strike price. Those that are white are “out-of-the-money”, meaning the share price is above the strike price; the opposite is true for the other side of the chain, which is for call options. The strike price is in the middle of the table and in this example, ranges from $31 to $37. Investors selling puts need to select their desired strike price after selecting the preferred expiration date. Lower strike prices offer lower premiums but also have a higher probability that the stock price won’t reach that level by expiration. The opposite is true of higher strike prices; more premium is generated but a higher probability the share price will finish under the strike price, thus assigning the shares to the investor at the strike price, regardless of the price the stock is trading for at assignment.
Let’s say this investor wants to generate significant income with a moderate risk of being assigned and selects the $33 strike price for December 21, 2018 expiration. That put option is trading for 81 cents today but since the put option is for a lot of 100 shares, the premium to the investor for selling the put is $81. For the put to be cash-secured, the investor needs enough cash in their account to cover the shares should they be assigned at expiration, which is the strike price ($33) times 100, or $3,300. In other words, by selling this put, the investor needs to hold $3,300 in their account to “secure” the put with cash in order to collect the premium.
The payoff here for the investor is that they collect the 81 cents immediately upon the sale of the put. The investor collects the 81 cents, which is 2.5% of the strike price, making this the absolute yield. However, in annualized terms, the put expires just 73 days from the time of the sale, meaning that if one annualizes that return, it is in excess of 12%. An investor could theoretically do this multiple times per year, generating $3 to $4 of option income per share, which compares favorably to the $2 per share dividend for AT&T using the same amount of capital. This is the power of selling cash-secured puts; yields can be much higher than simply owning high-yield dividend stocks or other income instruments.
Selling cash-secured puts isn’t necessarily for everyone. This strategy should be employed on stocks the investor wants to own anyway as the risk of the share price falling below the strike price means the investor may be assigned the stock. In addition, the investor is open to unlimited downside risk, as they would be if they simply bought the stock itself. However, taking these into account, investors can significantly boost their portfolio’s average yield by prudently selecting stocks on which to employ this strategy and actively managing their portfolio. In our example, AT&T shares yield just under 6% while the cash-secured put strategy yields in excess of 12% on an annualized basis. For sophisticated investors, this strategy can help generate more income from a portfolio without having to invest more capital in boosting the size of the portfolio itself.