Beginner Options Guide: 8 Simple Steps to Sell Cash-Secured Puts

Today I’d like to introduce a strategy that Warren Buffett himself has used many times via Berkshire Hathaway to reap billions of dollars — selling put options on quality stocks that we are happy to own.

In my opinion, this is a perfect strategy for the long-term investor. Layering on top of the buy-and-hold strategy, selling puts can boost my profits while allowing me to buy desired stocks at a discount. Read on to understand the rationale, my step-by-step beginner’s guide to execute this trade and my lesson trading JD.

Options Terminology

First things first, if options are a completely new concept to you, I highly recommend checking out Investopedia’s Essential Options Guide. Please do your own due diligence.

The most common way to think about options is it is an insurance. When we sign up with AIA for travel insurance, we agree for a 2-week period, we (the buyer) have the right to get claims for downside risks that may happen during my trip. AIA (the seller) has the obligation to reimburse me. For this contract, I pay AIA a premium amount.

Some terminology to be aware of:

• Strike Price = specific price
• Expiry Date = specific date
• Premium = value of the option, paid to the seller by the buyer = intrinsic value + time value
• Intrinsic value = exercise value of an option (if at or out of money, this is 0)
• Time value = quantifying the uncertainty due to time; the further out the option is, the higher the time value (at expiration, this is 0)
• In the money = positive payoff
• At the money = equal
• Out of money = negative payoff

Strategy: Sell Cash-Secured Puts on a Quality Stock

The Concept

So imagine you are a travel insurance agent selling insurance to travellers. They pay you a premium of $500 for a 1-month trip, for your word to cover their costs if an accident occurred.

They go on holiday, as days pass by, the value of the policy drops, since there is less chance of an accident happening (time decay!). If all goes well, the contract will expire and I keep the premium.

In the case of selling cash-secured puts, as a put seller, I agree to buy the stock at strike price anytime before the expiry date if the market price went below while pocketing a premium upfront. Cash-secured means I have the amount needed to buy 100 of this stock if exercised. I am not using leverage, which is the preferred approach.

Warren Buffett used this method to sell $37 billion worth of put contracts on Coca Cola, and received $4.5 billion in premiums. He believed in the long-term business model of Coca Cola. So he didn’t mind promising to buy the stock at a lower price to “insure” the buyers and in turn receive premiums which he used to invest in more securities.

Benefits

When done correctly, selling cash-secured puts has many benefits and can be safer than buying stocks outright:

• Downside protection in the event of a market crash
• Capital efficiency of spare cash while waiting to get in to the market
• Take advantage of high volatility during market corrections
• More total returns as you wait for the stock to come down to a price you are happy with while gaining a premium (win-win)

Drawbacks

Nonetheless, there are risks to be aware of:

• I must have sufficient collateral in the bank or brokerage account to buy 100 shares at the current price (cash-secured)
• Risk of price crashing below the strike price: even if it dropped to $0, I am still obligated buy the stock at the promised strike price (hence do options on high conviction stocks. That said, even if this happens, I’m better off selling a put than outright owning the stock)
• Returns are capped at the put premium, in a raging bull market I will miss out on the capital gains of the stock

Step-By-Step Guide

Stock Analysis

1. Check if the current market conditions are stable and not overheated

• Do not use the strategy if market is due for a pullback after a long run
• I like to look at the CNN Fear & Greed index as a gauge, avoid the extreme ends of the spectrum and wait

2. Perform due diligence with an investment framework to find strong quality companies that I am bullish on long-term

• Examples include Apple, Google, SPY… solid dividend history is welcome, as this is extra bonus for holding if option is exercised. However most of these large tech stocks are expensive in absolute terms, so one has to find the smaller caps to start off.

3. Check the stock has positive technical attributes (i.e. uptrend so as to avoid catching a falling knife)

• Above 20, 50 and 200-day moving averages
• RSI and MACD trending upwards

4. Check that I have enough cash to buy 100 shares of the company

Option Analysis

5. Ideal strike price: ATM or slightly OTM (below current price)

• Option value is made of only time value (no intrinsic value) for us to take advantage of
• Delta of 30 i.e. if stock increases by $1, option price will decrease by $0.30 (70% chance of not being assigned)
• Breakeven price should be a price you’re happy to buy this stock at

6. Ideal duration: 4–6 weeks

• Short term option has a higher level of time decay
• 1 month is ideal for me, as I can rinse and repeat on a monthly basis without tying up my capital

7. Ideal timing: short-term neutral/bearish and long-term bullish

• Examples: before quarterly earning reports, volatile market corrections or situations where implied volatility rises and investors will pay more for protection
• Sell puts on a Monday for an option that expires on a Friday: more days until the contracts expire = higher premiums

8. Exit strategy:

• Stock price is above strike price: let it expire on expiry date or buy to close at a low price; either way you collected your premium on the first day
• Stock price is below strike price: let it exercise, now you own 100 stocks at a price you’re happy with
• Stock price is below strike price: let it exercise, and continue with the wheel strategy
• Stock price is below strike price but you don’t want to own yet: buy back written put at a kiss and immediately sell next month’s put i.e. roll over

My Concluding Thoughts

Be patient — time is always on the option seller’s side. If everything else stays neutral, time premiums erode gradually, making it cheaper to buy back what was sold higher.

As they say, the best way to learn is to experience it yourself. Start small, with a lower priced stock and use the playbook. Note down lessons along the way to improve your own strategy, as I have. Hope you find this useful.