Imagine this: you just earned your drivers licenses after passing both DMV test and decide to purchase a car to celebrate your accomplishment. But before you are allowed get on the road, you need to buy some car insurance first (as required by most states). The insurance premium that you pay for protection is meant to be reassurance to you that if something were to happen while you were driving your vehicle, you would get some type of financial reimbursement for the incident. Of course you never actually want any type of scenario to happen to you or your car; but in case something ever does happen, having bought that car insurance gives you a sense of safety knowing that you are covered.

But now what if you’re on the other side of this transaction and instead of being the driver buying insurance, you are the salesman selling it. You need to determine what the risk is going to be like to insure this new driver, what car type and make they are driving, along with a multitude of other factors that will be used to figure out the premium and their own preferences for deductibles.

This is essentially what you are doing with cash secured puts. You are selling insurance to the put buyer according to the risk that is associated with the contract such as the Greeks, implied volatility, and chance of profit/ likelihood of being in the money. By doing so, you are giving them the reassurance that if the underlying stock falls to or below the strike price of the contract, you will buy their shares no matter how low the stock is at expiration, even if it reaches $0. In return for this reassurance, you collect the premium from selling puts to the buyer.

By using cash secured puts intelligently, consistently, and effectively, you will be able to generate extra monthly income for yourself on a yearly, monthly, weekly, or daily basis depending on your personal time frame.

What are cash secured puts?

Cash secured puts is a options strategy where you are selling puts in order to collect premium from the buyer of the contract. This is similar to the covered call strategy, where you are required to own 100 shares per contract you decide to sell so you are able to collect premium from the buyer.

The main difference between these two strategies is that you don’t own any shares of the underlying stock when you use cash secured puts. Instead, you need to have enough capital to put up for collateral in order to have the ability to purchase 100 shares per contract you sell if the put contracts were to ever be at the money or in the money during expiration. Remember, a put option contract gives the buyer the ability to sell 100 shares of the underlying stock to the put seller as long as the contract when conditions are met. This is why as a put seller, you need to have enough collateral to purchase those shares at the agreed upon price if the underlying is in the money by expiration.

Let’s dive into some examples to illustrate what I am talking about here using the Robinhood platform due to its friendly UI/UX. As of cash close on Monday, April 5, 2022, $SPY (S&P 500 ETF) closed at $451.03.

The reason why I chose this $442 strike expiring May 6 is because of its negative 30 delta that is expiring a month out (30 days). A 30 delta roughly means that there is a 30% of the contract being in the money at expiration.

Say you sold this contract, you would be collecting $539 ($5.39 * 100 due to options multiplier) in premium from the buyer. Your max loss for this trade is theoretically $43,261 if $SPY were to ever go straight to $0 (not likely to happen due to the nature of $SPY). Because you sold this contract, and assuming you don’t buy it back, you would need to purchase 100 shares per contract sold at the strike price of $438. Since you also collected the premium from the buyer for the contract you sold, you knock down your price price of $43,800 by $539 to $43,261. Therefore, your max profit for this trade is $539.

Notice how this strategy is different compared to a long put where the strategy involves you purchasing puts instead of selling them.

Theoretically for this trade, as the put buyer, you are paying $539 for this contract for the ability to make $43,261 if $SPY were to go to zero. Remember that as a buyer, the options tend to be over priced and is against you. The chance of this going to going in the money is about 30% while the chance of the options seller profiting the entire $539 is 75%.

Let’s use a different example where the underlying stock is in the double digits instead of the triple digits. As of cash close on Tuesday, April 5, 2022, $FCX (Freeport-McMoRan Inc) closed at $49.09.

One month out (30 days) $46p May 6 cost $148. To sell this one you would need to put up $4,600 for collateral. Doing this for one month successfully would increase your position by 3.2% ($148/$4,600) which means doing this for one year would increase your position percentage by 38.4%, almost three times higher than the average growth of the $SPY. Or, in other words, an extra $148 in income per month.

Note: Some numbers on Robinhood and OptionStrat are a bit different. I decided to stick with the numbers from Robinhood for consistency and left OptionStart graphs to visualize what the P/L would roughly look like.

Why would I use cash secured puts?

As demonstrated in the previous example with $FCX, using cash secured puts consistently and successfully on a monthly basis (or whatever time frame you’re working with) can either help you generate extra income or even outperform the market. But that’s not all cash secured puts can help you do.

Say you actually are looking at $FCX and from the thesis you have built you would like to have some exposure in this company. However, you think that the current price is overvalued and would prefer to have a lower entry. You have concluded that a reasonable price to enter this stock due to it’s one year trading range is at a high of $43 and low at $36. Looking at the $43 strike price with all else being equal:

we can see that this contract cost $73 each. If they go up in value before you are able to open a position for exposure, that’s fine because you were able to make a gain. If you still wanted to open a position because you strongly believe in your thesis, then just adjust the contract accordingly. Of course if you were a bit impatient you can move the contract you decide to sell closer to the money so you are able to collect higher premium along with a higher chance of being assigned the shares, ultimately reducing your cost basis.

Another way you would implement this options strategy is when you expect the underlying stock you are holding in your long term portfolio to go down and would like to both reduce your average cost and increase your exposure. You would sell puts on the underlying so you are able to reduce your cost basis and increase your holdings. This is great because timing the market is incredibly difficult to do and it is much more simple to have these contracts out and execute for you. If you happen to be wrong with your duration that’s fine because you got to collect premium and can do it all over again.

So how do I actually generate income using cash secured puts?

Depending on which ticker you are looking at, you would need to calculate how much it would cost you to buy 100 shares of the underlying stock so you know how much you need to put up for collateral. So if you were to have sold the $SPY $400p, you would need to have $400*100= $40,000 in your brokerage account to put up for collateral. If you sold the $FCX $40p, you would need to have $40*$100=$4,000 in your brokerage account for collateral; so on and so forth.

To execute this type of trade, you would want to look for contracts that are about 30 delta with 30 days from expiration. A 30 delta roughly means that the contract being sold has a 30% chance of being in the money by the time of expiration while selling the 30 day out contract allows you to take advantage of the exponentially decay of extrinsic value from these contracts. If your risk tolerance is higher then sell a higher delta, if lower tolerance than sell a lower delta.

You would also want to be aware of what the historic IV is for the ticker you are looking at and what the IV is currently at. Because you are selling contracts, you would want to capitalize on high IV so you are able to collect higher premiums. To find out what these numbers are, you can use resources such as Market Chameleon to help you. Another trick is to make sure that you have done your research on the underlying. Things like earnings, catalyst, trading ranges, and if the stock is trading at historical highs will all have an impact on the outcomes and pricing of your contracts.

Summary of cash secured puts

Cash secured puts is a short put options strategy that can help you outperform the market, generate extra income, or reduce your cost basis. As a put seller, you are essentially selling insurance to the put buyer. In exchange for premium, you are agreeing that you will purchase the underlying stock no matter how low the price of the shares fall to.

When you decide that you want to start using this strategy, consider the following:

• Take into consideration what the historical IV is and where it is currently.
• Do research on the company and look for catalyst.
• Take note of ER dates
• Understand what range the stock is trading.
• Pick tickers where you do not mind holding for a lot time in the scenario where you end up getting assigned.
• Sell contracts according to the delta (depending on your own risk tolerance) which are about one month out (30 days) in order to take advantage of exponential extrinsic decay.

For most individuals that are starting their journey into the equities market, they either begin with purchasing shares of a company, index fund, ETF, or a mixture – then proceed to hold onto these share for the long term, and dollar cost average into their position while they (hopefully) appreciate in value. However, during the past decade something miraculous changed: the introduction of commission free trading due to popular brokerage apps such as Robinhood effectively revolutionizing how the equities markets operate, especially for the retail investor. Then came the introduction of options trading in December 2017 on the Robinhood platform, opening doors that would allow anyone with an account to leverage themselves as much as could tolerate.

Retail investors on the Robinhood platform could now either open a call position, if they are bullish, or puts, if they are bearish, based on their thesis. And for most individuals that are using any brokerage service, their education about options tend to stop here – aside from maybe learning about the Greeks, which are used to determine the price of any options contract. But what happens when instead of buying these contracts, you are on the opposite side of the trade and actually sold them instead? Due to its simplistic nature, the covered call strategy is usually one of the first options strategies recommended for beginners, and when used correctly could help you generate extra monthly income.

What are covered calls?

Before diving into what covered calls are, let’s first take a step back and give ourselves a quick reminder about what a call option is. A call option is a bullish position where you are purchasing a call contract for the right to purchase 100 shares of the underlying stock, as long as the underlying stock either reaches, or surpasses your strike price at or before expiration. This position has theoretically unlimited profit potential with the risk of losing all the money you spent to buy this contract, also called the premium. On the other side of this trade, if you are the seller of the call option contract, you are selling the right to give the buyer the opportunity to purchase your 100 shares of the underlying as long as the underlying stock hits or surpasses the strike price at or before expiration. By doing this, you are agreeing to limit your upside potential with the shares you own in exchange for the premium paid by the call option buyer. If these requirements don’t happen, the call options seller keeps both their 100 shares and premium collected from selling the contract.

Now let’s illustrate what I’m talking about by using some real examples with $SPY from the Robinhood platform. As of cash close on Friday, March 25, 2022, $SPY closed at $452.69.

I chose the $463 strike price because its delta is at 30 and the April 25 expiration date since it is a month out, giving us 30 days until expiration.

If you were to purchase this contract, you would need to pay $352 in premium due to the options multiplier ($3.52 * 100 = $352). Your max loss is the amount of money you paid for this contract, which is $352, and your profit potential is theoretically unlimited. Even if $SPY hits $463 at the time of expiration and you get the right to purchase 100 shares of $SPY, you still need $SPY to reach $466.52 in order to break even at expiration (as shown with the graph above).

On the other side of that trade you have the seller that is collecting premium. But since we are talking about a covered call strategy here, the seller would also need to purchase 100 shares of $SPY ($452.69 * 100 = $45,269) in order to protect themselves. Selling this call option contract would net the seller $352, reducing the cost basis for this strategy to $44,917. The max potential loss for this would be the full $44,917 while the max potential profit would be ($352 + (($463 – $452.69) * 100)) $1,383. While the idea of losing $44,917 is mind boggling, the chance of that happening is near zero unless it’s the world is ending. Also notice here that the break even point is at $449.17 since the seller collected the $3.52 in premium ($452.69 – $3.52 = $449.17). Collecting premium reduces the sellers cost basis.

What happens if I don’t own the shares and the contract gets exercised/ shares are called?

What makes this a covered call strategy is that you are covering yourself because you actually own 100 shares of the underlying stock in order to protect yourself while selling a call. If you do not own the 100 shares of the underlying you are participating in something called a naked call, also known as a short call, where you are selling the contract without owning any of the shares you are promising to sell to the buyer. Using the same example as before, your max profit is $352 while your potential loss is theoretically infinite. As the saying goes, you’re “picking up pennies in front of a steam roller.”

If $SPY were to hit the strike price of $463 and the contract was exercised, as the call seller you are now obligated to sell the call buyer 100 shares of $SPY at $463. So if you did not own the said 100 shares of $SPY already, that means you would need to spend $46,300 to purchase the shares so you can sell them back to the call buyer. The worse case would be when $SPY goes beyond that $463 strike price. For example, if $SPY hit $475, you would need to purchase 100 shares of $SPY at $475 and then are still obligated to sell those same 100 shares to the call buyer at $463. This would be a loss of $1,200.

Why would I use covered calls?

The covered called strategy is multi-purpose depending on how you decide to use it.

In the scenario depicted above within the “What are covered calls?” section, you would use the covered call strategy to initiate a position you plan on holding for a short period of time with the intention to trade. Ideally, the call you sold would either be at the money or in the money by the time the contract expires, allowing you to sell the shares for the agreed upon price as well as keeping the premium. The ability to collect premium allows you to both: have downside protection by reducing your cost basis if the stock drops in value and allows you to squeeze more money if the underlying appreciates to or above the strike price. You would not care about how high the underlying stock appreciates in value because your covered call position is complete.

Another scenario you would use covered calls for is when you want to begin devesting your positions. Say you bought 100 $SPY shares back when it was $300 and now you feel comfortable enough to sell at $452.69; that is a gain of 50.9%. Instead of selling your shares, you could instead sell calls to squeeze additional money from your position. If the underlying doesn’t hit your strike price, you get to do this over again until the contracts get exercised. So instead of that 50.9% gain, your returns would actually be much more. If this is your intention and you want to ensure that your shares get called, you would gravitate towards higher delta options.

A third scenario would be if you wanted to reduce the cost basis on your position with the intention of holding for the long term. For example, if you wanted to hold $SPY shares for the long term and you purchased them at it’s current price of $452.69, you could sell the 30 delta monthly call on a monthly basis for $3.52. If you successfully did this for a year and managed to collect premium without the shares being called, (12 * $3.52 = $42.24) you would have reduced your cost per share from $452.69 to $410.45.

It’s also interesting to note that the Chicago Board Options Exchange (CBOE) created an index (BXMD) to track the performance of a hypothetical covered call strategy that holds long term $SPY positions that sell monthly out of the money call options with strikes nearest to the 30 delta. The results show that this strategy consistently outperforms the S&P 500.

To sum up this section:

• Initiate a short term trade position with the intention to unload your shares while adding downside protection from collecting premiums
• Devest holdings
• Reduce cost basis for long term holds
• Outperforms the S&P 500

So how do I actually generate income using covered calls?

In order to generate income using covered calls, you first need to own 100 shares of any security, either that be from a public company, index fund, or ETF. You would sell the monthly (as close to 30 days) call in order to take advantage of the exponential rate of decay due to theta.

Assuming that you don’t actually want your shares to get called, you would want to focus a bit more on the chance of profit from selling these contracts instead. Now, depending on your own risk tolerance, this is were you would decide on the contract you are selling based on the delta. Using the example from earlier:

The $463c April 25 call cost $3.52 with a 77.16% chance of profit. If you were to lower your delta by 10 and sell the 20 delta instead:

You would be looking at a 5% increase in the chance of profit in exchange for ($3.52 – $1.97) $1.55 in premium. If that 5% assurance to you is worth the $155 you lose from 10 delta, then you should sell the 20 delta, if not, the 30 delta. It really depends on your own risk tolerance.

Another important thing to consider when selling calls is what the implied volatility (IV) is. Understanding the historic IV as well as the current IV would allow you to maximize the premiums you collect.

Alternatively, if you don’t have enough money for this strategy you can employ a poor mans covered call. Instead of owning 100 shares, you can instead purchase a deep in the money call that is far dated, and sell a shorter dated out of the money call. This strategy is more risky and complex so not advised for beginners.

Quick pointers on covered calls

Depending on what you plan on doing with covered calls, the delta you are selling matters. Higher the delta, the higher the likelihood of the underlying being at or in the money. Further the delta, the lower likelihood of the underlying being at or in the money.

When it comes to the expiration date, go with call options that expire within the month. This is because the extrinsic value of the contracts decays at a exponential rate, especially when it comes to theta (#thetagang).

Buying shares of a company is pretty straight forward. You look up the ticker or name of the company, place an order, and receive said shares. The only things you really need to be concerned about is what company, how many shares, and if it’s trading at a reasonable price.

When it comes to stock options, there is much more thought needed to go into your game plan. Adding to the previous list, you also need to be concerned with what strike price, expiration date, and even likelihood of the contract going in the money or not. However, if you have strong conviction about the movement of a stock, in this case to the upside, you could purchase in the money calls or out of the money calls. The use of leverage to multiply your returns is much more than just holding plain ol’ stocks; that’s the appeal of options right? But the certainty of these contracts you buy that are in and or out of the money being in the money at expiration is not 100%. Though these contracts are much cheaper, you can’t take full advantage of the intrinsic value with these contracts. They’re either only valued extrinsically (out the money) or a mix (in the money; remember that the delta is .50). By utilizing deep in the money call options, you are taking advantage of the upside potential through its intrinsic value from a shorter time frame, have protection from downside, and cost cheaper than its stock equivalent. Deep in the money call options also eliminates the anxiety associated with worrying about whether or not your contracts will be in the money.

Let’s use a real example to demonstrate these points:

I will be using the Robinhood desktop website because of it’s friendly UI with $SPY as the ticker.

As of March 3, 2022, the price of $SPY at cash close was $435.73. As a refresher, contracts that are considered to be deep in the money are at least 10% below the price of the underlying. Therefore: $435.73 * 0.90 = $391.50. I will also be using LEAPs as the contract expiration, in this case December 30, 2022. This gives us about 9 months til expiration, or 303 days. Also because these later dated contracts are priced in increments of $5, I will be using the $390 strike.

Remember that each contract is the equivalent of 100 shares of the underlying.

If you were to purchase 100 shares of $SPY at $435.73, that would cost you $43,573. However, by utilizing the $390c 12/30, instead of forking out a eye boggling $43.5k, this contract will cost $6,646. That’s a staggering difference of $36,927! If you were to use the same amount of capital from those 100 shares of $SPY for $390c 12/30, you could get 6 contracts. 6 contracts multiplied by 100 gives you the exposure equivalent of 600 shares, 500 more than shares for the same amount. To summarize this section:

• 100 shares of $SPY at $435.73 = $43,573
• 1 contract of $390c 12/30 @ $66.46 = $6,646
  • Difference of $36,927 for same exposure
• Or with the same amount of capital:
  • 6 contracts of $390c 12/30 @ $6,646 per contract = $39,876
  • 5x the exposure while still having some money to spare

So this means at every dollar increase, the 100 share will gain $100 while the $390c 12/30 contract will have a gain of $100 (more or less depending on delta). This is only if the underlying goes up in value. On the other hand, if the underlying goes down in value, it will lose $100 per dollar loss while the contracts will lose about $100 (again, depends on delta).

There are disadvantages to using option contracts than shares of course. The biggest one being that option contracts are time restricted, and the closer to the expiration date the more extrinsic value is lost due to theta. But with deep in the money calls, that shouldn’t be too much of a concern. There’s also the disadvantage of not getting dividends. Currently, $SPY has a dividend yield of 1.33% which comes out to be $579.52 annually with 100 shares. Lastly, no matter what time frame your contracts are, realizing gains from options will always be taxed as short term capital gains.

Option contracts act like stocks but they aren’t stocks. They can be a replacement assuming that you will hold onto this position for a couple months. Usually, when individuals purchase option contracts they do not really have the intention of exercising them, but remember if shares are ultimately what you would want, you can do so if desired.