I would love to claim this article as my own, but alas, I cannot. I gleaned it from the daily email from Casey Research that I am entitled to get as a subscriber – one of many benefits.
But as a former stock broker and investor with 30 years experience including writing put options, I can vouch for the information being top notch. Read on…
Get Paid to Buy Stocks on the Cheap
It’s true stocks have fallen off somewhat recently. The S&P 500 is down about 6% from where it was a month ago. But stocks are still quite expensive in historical terms. Birinyi Associates reports the current S&P 500 P/E ratio (based on trailing twelve month as-reported earnings) to be 25.96, more than 60% above the long-term 15.98 average P/E ratio I calculated using Standard & Poor’s quarterly data.
These are challenging times. And being a smart investor is as important as ever.
Which brings us to a surprisingly simple strategy that allows you to buy a stock you want to own anyway, but at a discount to the current market. And, just for trying, you get paid.
Here’s how it works:
Step 1: Select an undervalued stock you want to own
To state the obvious, you first need to identify a stock you want to buy – perhaps easier said than done in today’s markets. But for now let’s just assume you’ve found a stock you want to own.
Step 2: Sell put options on the stock
Having selected a stock you want to buy, you now need to decide on the price you want to pay. Your broker, live or discount online, will have the list of put options available with a range of “strike prices” (the price you are willing to buy at) and expiration months.
Assume you want to own stock in Apple Inc. (AAPL). At this writing, Apple is trading for $202.50, but you don’t want to pay any more than $180 per share. So you would select the put option with a $180 strike price and an expiration month, of, for this example, March 2010.
Now, place an order to “Sell to Open” those put options. Since each option is equivalent to 100 shares, if you want to buy 300 shares at $180, you’d Sell to Open three put option contracts
- Important: By entering this trade, you’re obligating yourself to buy the shares at the stated strike price, on the expiration date. Thus, if you sell three $180 put option contracts on Apple, you’ll need to have $54,000 on hand to cover the cost of the shares ($180 strike price x 100 shares per contract x 3 contracts = $54,000).
(Note: This is just an example. And we happen to have picked a very expensive stock. You won’t need to have nearly as much money on hand to sell puts on most stocks.)
- Even More Important: Triple-check your order before finalizing it. Remember, a put option is not the same thing as a share. It is a binding contract that obligates you to buy 100 shares of the underlying equity at a specific strike price on or before a specific expiration date. By confusing shares with option contracts, more than one investor has made the potentially devastating mistake of placing an order to sell 100 put options, when they really just wanted to sell one.
Step 3: Get paid
In exchange for agreeing to take on the risk of guaranteeing the option buyer that you’ll buy the Apple shares at $180 – should the price fall to that level – the buyer will pay you a “premium” for each contract you sell. This premium is deposited into your trading account. To give you a sense of the thing, at this writing, the premium available on an Apple $180 put option for March 2010 expiry is $1.32 per share, or $132 per contract.
So, in our example, you could collect $396 cash on your three contracts while you wait for the asset you want to buy to decline in price. Not bad, huh?
(Note: Your premiums will vary depending on what you sell and when. Generally, the higher the level of volatility, the higher the premium.)
Without this strategy, your choices would typically come down to buying at the market and hoping the stock moves higher… or placing a below-market bid and hoping your price is hit. In either case, you don’t collect the premium.
So far, so good. But what happens next?
Step 4: Exercise Date
After you have sold your put option, you get to sit back and see what happens to the price of the stock. Below are the possible scenarios – but remember, regardless of the outcome, you keep the money you’ve already pocketed from selling the put options.
- Scenario #1 – At the exercise date, the stock is trading at or below the strike price which, in this hypothetical example, is $180 (referred to as being “at-the-money” or “in-the-money.”)
For every put option contract you sold that gets “put” to you, you’ll be obligated to buy 100 shares at $180 each. This is a terrific result. You now own the stock you wanted at an 11% discount from its $202.50 price when you executed the trade, plus, you get to keep the premium you received when you sold the put, reducing your net cost to just $178.68 a share, in this example.
- Scenario #2 – The stock trades above $180 (i.e., out-of-the-money)
The put options you sold will expire worthless. Which means you won’t get to buy the shares at your chosen price. But, just for trying, you have the consolation prize of getting to keep the $396 premium you earned for selling the contracts.
What Can Go Wrong?
Before you even think about selling a put option, it’s imperative to have all the funds necessary to cover the cost of the stock you have committed to buy. American options can be exercised at any time during the life of the contract. So you could sell a put option today, and the stock could be “put” to you tomorrow if the buyer of the option decides to exercise it.
You should employ a no-risk strategy when it comes to selling puts. In order for this strategy to work as a no-risk strategy, never forget the following rules of thumb:
- Do not write (sell) more puts than you are willing to own had you just bought the stock outright.
- Do not use leverage. Always have enough cash on hand or in liquid securities to cover the cost of the contract.
- Do not sell puts on any stock that you would not be absolutely ecstatic to own. A disciplined approach is crucial.
- Don’t be scared. As long as you stick to numbers 1-3, you should find selling puts to be a great way to get positioned in stocks you want to own at a discount.
- (Note from Roger) Keep in mind that if some bad news on this stock tanks the price, you will probably own it, and may not want to. On the other hand, the market many times over penalizes a stock, you buy on the cheap, and it rebounds a day or so later when cooler head prevail and the stops have already been run.
Put options are available on thousands of stocks. You’ll probably be able to find a put for every stock on the NYSE, AMEX, and NASDAQ, but the number of different puts available will vary depending upon historical volume and volatility of the underlying stock. For example, Apple Inc. currently has 22 listed put options expiring in March 2010, but most stocks will probably have fewer listed put options expiring in March 2010.
A final advantage of using this strategy to enter your stock positions is that it can help you become a more disciplined investor as it encourages placing below-market orders, versus chasing stocks on a run.
While selling put options is a great strategy to get positioned in stocks you want to own on the cheap, it is but one of the many options strategies you as an investor should be aware of. It just so happens that in this month’s Casey’s Extraordinary Technology (due out in about a week), senior editor Alex Daley introduces two more options strategies that will help you as an investor maximize your upside potential and minimize your downside risk…absolutely crucial when it comes to volatile tech stocks. In fact, with one of his strategies you could earn the equivalent of a 17% dividend on a stock that doesn’t even pay one; all while protecting yourself against a big loss. So why not check out a risk-free trial of Casey’s Extraordinary Technology, you won’t be disappointed. Details here.
