Why Smart Investors Choose Cash Secured Puts Over Limit Orders

When I first started investing, I have only relied on limit orders to purchase stocks.

Typically, when purchasing a stock at a targeted price point, it is common practice to place a limit order for buying shares and specify that the order remains active until cancelled (referred to as a good till cancelled order).

The order is placed with the anticipation of a stock’s price dropping to a specified limit. The limit order triggers an automatic purchase once that level is reached.

In the end, one of two results will occur: the order will be either executed or cancelled.

Is there a more effective way to acquire stocks while also reducing the risks associated with stock ownership?

Thankfully, the answer is yes.

My viewpoint changed when I discovered a better method involving options—specifically, through selling cash secured puts.

What Makes Cash Secured Puts A Smarter Way To Acquire Stocks?

To the uninitiated, cash secured puts involves selling a put option while having enough cash on hand to buy the stock if needed.

Essentially, it’s akin to setting a limit order for buying the stock with one important difference: By opting for cash secured puts instead of a limit order, traders can earn income (known as options premium) by agreeing to purchase shares.

This income remains yours regardless of whether the stock hits the strike price or not.

The income can then be utilized to offset the cost associated with purchasing the stock eventually.

Looking at it from another perspective, you’re getting paid for committing to purchase a stock at a lower price in the future.

Sounds amazing, isn’t it?

Comparison Between Cash Secured Puts and Limit Orders

Here’s a quick overview comparing limit orders and cash-secured puts.

• Limit Orders: Guarantees the purchase of the stock at your designated price if it falls to that level, but you don’t earn any premium.
• Cash Secured Puts: Gives you the opportunity to purchase the stock at a lower price, all while receiving an initial premium.

As you can see, both methods are quite similar.

The primary distinction lies in one providing additional income while the other does not.

A crucial difference with options is that the stock won’t be automatically bought when it hits the strike price, unlike with limit orders.

Typically, the stock must be below the strike price by the expiry date for the purchase to occur.

Illustration Using Google Stock

Let’s explore the difference between utilizing cash secured puts and limit orders in a hypothetical example for acquiring Google stock.

Suppose you want to buy Google stock (currently trading at $155 per share) but believe it’s slightly overpriced at the moment.

You can either place a limit order or sell a cash secured put at a price below the current market value.

• Limit Orders

Employing a limit order involves setting a specific buying price for Google stock – let’s say $150 per share.

If the stock price hits the limit order at any time, the order will be executed.

However if the market value remains above $150, then your order will not be processed and no shares will be acquired.

Your effective cost per share will be $150.

• Cash Secured Put

Using options, you can opt to sell a cash secured put with a strike price of $150 expiring in one month.

By doing so, you would receive a premium (e.g. $3 per share) upfront.

If the stock price stays above $150 by expiration, you retain the premium as profit.

In another scenario where the stock price drops below $150 by expiration, you are obliged to buy the stock at $150 per share but with your effective purchase price reduced by the premium received.

Assuming you received $3 in options premium, your effective cost per share will be $147.

Can I Do The Same Method For Selling Stocks?

Certainly! When you utilize options to sell stocks you already own, it’s referred to as a covered call. It’s termed “covered” because you already possess the stocks, and if your call is assigned, your stocks will be sold at the assigned price.

The fusion of cash secured puts and covered calls creates a widely-used options strategy known as the Wheel Strategy.

When employed to acquire high-quality companies, it offers a safer approach compared to someone solely relying on limit orders.