A Case Study on the Cash Secured Put

In previous articles, we discussed the main options Greeks, including Gamma, Delta and Theta.

Today, we will explore the Cash Secured Put.

1.Cash Secured Put: Potentially lower your stock purchase cost with options

If you want to buy stocks at a favorable price, what would you usually do? Many investors would draw trend lines and use technical indicators to estimate the potential bottom price before placing a limit order.

However, some investors may consider using cash-secured puts. This strategy involves selling put options with an expected lower price as the strike price to collect premiums. If the put option is exercised, the cost of buying the stock is reduced to (the stock price - option premium).

This strategy has at times been successful for Warren Buffett, who has used it in two famous cash-secured put practices: one on Coca-Cola in 1993 and another on the stock market index during the 2008 financial crisis. Let's take a closer look at these two cases.

2.Collecting US$7.5 million option premium from short Coca-Cola puts

Did you know that Coca-Cola is Warren Buffett's favorite beverage? Since 1988, he has invested in the company several times, making it his largest position in the stock market. By 1993, Buffett had earned nearly ten times his initial investment return through Coca-Cola.

Despite his long-term optimism for Coca-Cola, Warren Buffett was aware of the potential short-term pullbacks in the stock price. To help manage this risk, he used Cash-Secured Put options.

In April 1993, with Coca-Cola's stock price hovering around US$40, Buffett sold 5 million put options with a strike price of US$35 and an expiration date of December 1993 for an option premium of US$1.5 per share. Let's compare different possible scenarios:

1. If Coca-Cola's stock price remained above US$35 until expiration, the buyer would not exercise the option, and Warren Buffett would make a net profit of US$7.5 million (US$1.5 * 5 million).

2. If the stock price dropped below US$35 on the expiration date, the buyer would exercise the option, and Warren Buffett would be obligated to purchase 5 million shares of Coca-Cola's stock at US$35 per share, plus the US$1.5 option premium previously collected. His final cost of purchasing would be US$33.5 per share.

Compared to placing a limit order at US$35, the cash-secured put strategy brought Warren Buffett additional profits. If the stock price did not drop to US$35, which was his psychological price, no losses would be incurred.

It's worth noting that from 1993 to 1994, Coca-Cola's stock price fluctuated between US$40 and US$45 and never fell below US$35. This meant that Warren Buffett failed to buy Coca-Cola stock at his desired price. However, the cash-secured put still made him a net profit of US$7.5 million in option premiums.

3.Collecting US$4.9 billion premium from short S&P 500 puts

The financial crisis of 2008 hit the US stock market hard: housing prices plunged as the bubble burst; Lehman Brothers went bankrupt; large sell-off began as bailout plans got rejected.

Despite the challenging economic conditions and a declining market, Warren Buffett still profited from cash-secured put options. According to Berkshire Hathaway's 2008 annual report, derivatives provided US$8.1 billion worth of premiums, with S&P 500 put options earning US$4.9 billion in option premium income.

It should be noted that unlike the example of Coca-Cola in 1993, Warren Buffett sold long-term options this time. Although the marked-to-market losses of these options reached US$10 billion during 2008-2009, as the stock market gradually recovered, Warren Buffett's put options survived a very difficult period and eventually collected the $4.9 billion option premium.

4.Factors to consider before conducting cash-secured put

Before conducting cash-secured put, investors need to take into consideration some factors.

First, define the goal. Generally speaking, there are two reasons for shorting cash-secured puts: expecting to receive option premiums or purchasing related stocks at a lower price. If you only expect to receive option premiums, you can consider deep out-of-the-money options approaching expiration. If you want to buy the dip of a stock like Warren Buffett in the Coca-Cola example, don't overlook the two premises:

1. You hold a long-term bullish outlook on the underlying stock and are willing to hold it for the long term.

2. The price has potentially reached the bottom in the short term.

Second, understand the risks.

1) Margin risk

When selling put options, sellers face greater potential risk than buyers, which is why they need to deposit margin before selling options. Before conducting cash-secured put, be sure to check if your margin status is normal.

2) Limited profit and high risk

Sellers should pay close attention to risk management, as their profit is limited but their potential losses can be high, with the maximum loss occurring if the underlying stock price falls to zero, though this situation is rare.

3) Possibility of missing out on opportunities for big rise

The premise of buying stocks at a lower price through this strategy is that the options can be exercised. If they are not exercised, sellers will not be able to take advantage of any potential stock price appreciation.

Last but not least, I've summarized all possible scenarios that may occur after the Short Put expires.

That's all for today! Please feel free to leave a comment if you have any questions or thoughts. Don't forget to follow us to stay up-to-date on all things related to options trading. For more information of options learning, you can click on the image below to follow me immediately!