Guest post by Gavin McMaster, founder of Options Trading IQ.
The world of options can seem a foreign place when people first encounter it. It’s rarely, if ever, mentioned in mainstream media. But did you know that Warren Buffett is known for using put options to buy stocks for less extensively in his investing?
An option is a contract between two parties giving the taker (buyer) the right, but not the obligation, to buy or sell a security at a predetermined price on or before a predetermined date. To acquire this right, the taker pays a premium to the writer (seller) of the contract.
- Options can be used for hedging, risk management, leverage or speculation and have the following features:
- Underlying Asset – The instrument for which the option contract relates
- Call vs Put – The type of contract being traded
- Contract Size – Most options represent exposure to 100 shares
- Expiration Date – The date the options contract expires
- Strike Price – The predetermined price for buying or selling the underlying asset
- Premium – The price of the options
Cash Secured Puts
A cash secured put is a conservative options strategy that can be used to purchase a stock for lower than the current price.
Let’s assume XYZ Corporation is trading at $100 and an investor would be happy to buy it for $95.
Instead of waiting for a pullback (which may never come), the investor can sell a cash secured put with a strike price of $95.
If the $95 puts are currently trading for $3.20, then the investor would collect $320 in premium.
He also has an obligation to buy 100 share of XYZ at $95. For this reason, he needs to have at least $9,500 in his account.
It’s important to remember that even if the stock drops to $50 between now and the expiration date, the trader still has to buy XYZ for $100.
Let’s say XYZ does fall below $100 and the trader is assigned 100 shares. The total cost would be:
100 x 95 – 320 = $9,180.
This gives an effective purchase price of $91.80. Certainly better than buying it at $100.
What Are the Risks?
Every strategy has its risks and this one is no different. There are two scenarios that create a downside in the strategy of put options to buy stocks for less.
First, if the stock does not move lower but instead moves higher.
If this happens the investor will not be assigned on the stock, which means they will not receive the shares they wanted.
As the stock moves higher, they will be left watching and missing out on the gains it could have provided.
If the stock makes a huge move higher, a cash secured put strategy will significantly underperform outright stock ownership.
For this reason, cash secured puts are best used on stocks on which the investor has a neutral to slightly bullish outlook.
I love using this strategy on high-quality blue-chip stocks. Basically anything in the Dow 30 Index.
The second situation is having the stock move lower and then continue to move lower.
In an ideal world, you would want to the stock to move to your strike price, get assigned the shares, and then have the stock take off higher.
Unfortunately, things don’t always work out this way.
But, think about it this way, if you were happy to but XYZ at $95, you are still better off because your cost basis is slightly lower at $91.80.
Also, remember that if you are assigned shares, you can continue to generate income from those shares in the form of dividends and selling covered calls.
If you are a long-term investor, or just want to acquire stock at lower than the current price, using put options to buy stocks for less with cash secured puts can be a nice way to do that.
They have several advantages if you can afford the time to wait and you get the added bonus of being paid while you wait to take ownership.
About the Author
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Gavin has written 8 books on options trading and you can find more from him at www.optionstradingiq.com.
Side Note: If you are looking for a beginner article on investing (to get your feet wet before jumping into action with Gavin using put options to buy stocks for less), check out my article on The Beginner’s Guide to Investing.