Selling (Writing) put options (Out of the Money) is an effective strategy to buy a stock at a discount to current prices.
The short version: by selling out of the money (OTM) puts on the stock of a quality company you actually want to own, you’re getting paid to make an offer to buy that stock for less than what it’s trading for today.
Consider this example: ABC Nutrition is priced at $52 per share. You’re confident in the company’s quality and aim to make it a cornerstone of your portfolio. Yet, you recognize that the lower your initial purchase price, the higher your potential long-term returns.
1 month out, the bid on the $50 cash secured puts is $1. You go ahead and write (sell) the put and collect $100 in premium. From a value-based option investor’s perspective (à la Warren Buffett), there are three possible outcomes:
- As long as the stock stays above $50/share, the put option expires worthless and you keep the $100. In this example, that equates to a 2% return on the potential capital outlay of $5,000 (100 shares at the $50 strike price). Since this was a one month holding you need to multiply your 2% return by 12 to arrive at a 24% annualized return. You are then free to repeat the same process, selling puts on the stock again and collecting premium.
- If the stock is trading below $50/share at expiration, and you haven’t bought back the put or rolled it out, you will be obligated to pony up $5,000 for each option contract you sold. But because you already received the $100 in option premium, you are, in effect, only paying $4900. Your adjusted cost basis on the position is now down to $49/share. This beats buying the stock for the $52/share it was trading at when you first liked the look of it.
- If the stock is trading in the $49.5-$50 range as expiration approaches, you have a choice to make. You can do nothing and allow the option to be assigned. This means you acquire the stock at the adjusted $49/share price. If you go that route, even though the stock price has declined, you’re still ahead since your adjusted cost basis is less than the current stock price. Your other choice is to roll out the put. To do this, you buy back the option that’s expiring and sell to open a new one another month out to accumulate extra premium. This extra premium serves to lower your cost basis on the stock even more. And as long as the stock price is close to being at the money, you should be able to generate enough additional premium to make this a wise choice.
Benefits of Selling Put Options to Buy A Stock
There are two main benefits to selling puts out of the money as a method of acquiring a stock you want to own:
- It’s impossible to buy a stock at its exact top when you sell OTM puts.
- Having a lower cost basis per share paves the way for higher compounded returns in the future.
Initially, by acquiring the stock through put writing, you’ve already benefited by paying less than you would have in the open market. Moreover, once you own the stock, you have the opportunity to implement further option strategies, like covered calls, to generate extra income.
Depending on how you prefer to slice it, you can view any additional premium as an extra return or a kind of special dividend. Alternatively, you can consider it a refund from your initial purchase, further reducing your adjusted cost basis.
In addition, you also have the flexibility to adjust the strike price on your initial puts. If a top-tier company’s shares are trading at an exceptionally low price, it might be more beneficial to write puts at or even in the money, rather than out of the money.
This approach allows you to earn more premium (offering downside protection if the stock keeps falling) and increases the likelihood of acquiring the stock at a discounted price.
Or, if you come across a rare opportunity that only arises once in a decade, why complicate matters with intricate options strategies? In certain cases, it might be more advantageous to simply take the direct approach and purchase the stock outright in the open market.
Lastly, utilizing out-of-the-money put writing to attain discounted shares in outstanding companies is generally a secure and profitable strategy. Assuming you’ve conducted thorough research and selected undervalued, high-quality companies, the primary risk leans towards the upside, not the downside.
If you’ve done the work, it’s highly improbable to incur losses or even underperform the market in the long run. In the short term, during strong bull markets when stocks are soaring, this put selling strategy may not keep up. However, momentum markets eventually face a reckoning day, a day that value-based option investors (like ourselves), are uniquely positioned to navigate.
With options, you have the freedom to design a customized roadmap to success. There’s a wealth of combinations to delve into, making the process enjoyable, gratifying, and ultimately rewarding.
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