Posted by Let’s be clear.
Fellow Philadelphian and cheese steak aficionado Jim Cramer may be a great stock picker and market analyst/strategist. But one ingredient SaferTraders will love is missing from his recipe for establishing a stock position.
Like many market scholars, he advises investors to initiate a stock position with only part of the total amount of the stock they have in mind. Specifically, if the plan is to own 1000 shares of XYZ, buy 500 shares now and wait to buy the other ½ of the position later at a lower price if the stock retreats somewhat.
That way, if the stock takes off right away, you do participate in the move up via the stock you bought, and if the price retreats first, you buy the rest of your position at an even better price. Thus, your average entry price is lower than if you’d bought all 1000 shares at today’s price. As Jim would say: booyah!
In fact, many market advisors and investors favor waiting for a stock that interests them to trade near a technical support level before entering the market.
In both cases, you are “waiting” for a more desirable entry price before establishing part or all of your position.
But here’s the missing ingredient: you can get paid handsomely while you’re waiting to make your first, or the rest of your purchase!
Sell the Put Option
Here’s how it works.
Example 1: XYZ is currently trading at $85/share. Looking at the XYZ daily chart, we see that there is strong support at $78-79, but of course we have no assurance XYZ will trade down near that support before moving higher. So Jim might advise that we buy 500 of our planned 1000 shares here at $85, and be prepared to buy 500 more if the stock retreats to $80.
Example 2: Alternatively, we might be thinking that because XYZ has had a nice run up recently, it is likely that there will be some profit taking that could take the stock back to the support $5-6 lower, and we’ll just wait to make our entire purchase at $80 if it trades at that level.
In both of those two scenarios, we are “waiting.”
Now, let’s get paid for our patience.
We look at the list of XYZ options and see that this month’s XYZ “puts” with a strike price of 80 are trading at $1.50. The buyer of this put has the right, but not the obligation, to exercise his put and thus sell 100 shares of XYZ stock at the $80 strike price any time up to and including the expiration day of the option. He would only exercise that right, of course, if the stock got down below $80 on option expiration day.
The seller of that put (that would be you in these examples) has the obligation to buy 100 shares of XYZ at $80 if the owner of the option exercises it. That suits us just fine, of course, because although we didn’t want to pay the $85/share the stock is trading at today, we pre-determined that we would be happy to buy the stock at $80.
Since each option is for 100 shares of stock, and in the second example we want to pick up 1000 shares if the stock trades at $80, we would sell 10 XYZ puts with a strike price of $80. Since the put option is trading at $1.50, we would collect $150 ($1.50 x 100 shares) for each put option, or a total of $1,500 for the 10 puts we sell.
Now let’s look at the two possible outcomes:
1. The stock does not get down to $80 prior to option expiration: The buyer of the 10 put options does not exercise the puts and he has lost the $1,500 premium he paid for the options. YOU keep the $1,500 you got for selling the puts to him.
2. The stock is below $80 at option expiration day: The buyer of the 10 put options exercises them and you buy 1000 shares of XYZ at 80, as you wanted to do. You also keep the $1,500 you got for selling the puts.
The Bottom Line.
You keep the money you received for selling the puts NO MATTER WHAT HAPPENS.
If the stock price reaches or goes below the put option strike price at expiration you buy the stock at the strike price (the lower than current market price you wanted to pay in the first place) when the option is exercised. In effect, you are getting a stock currently selling at $85 for $78.50 (the $80 strike price – $1.50 premium you collected up front).
If the stock doesn’t get down to $80, you just keep the premium.
SHAZAM! It’s a true Win-Win.
Is there any downside to this option technique? Only in the sense that if the stock never reaches the strike price you selected ($80) in these examples, you would not own the stock you were considering. That’s why Mr. Cramer suggests buying part of your desired final position “now” and the rest if there is a drop to a lower price. But even if you don’t get the stock at the below current market price as desired, you get paid anyway by the premium you collected up front on the sale of the puts.
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Lee Finberg
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Lee –
I’m glad you have this article. While reading your book where spreads are emphasized, I kept thinking to myself “except in this case.” I purchase possibly 1/3-1/2 of my long stocks with your strategy above.
I use this especially when I would like to own a long stock on a stable company. Even if the mark goes below the effective discount price ($78.50 in your example), I have still bought the stock at a bargain price typically.
Thanks Lee. I’m impressed with your conservative system and I plan to give it a go. I’ve made my first “Machine” sale this week.
I really like this idea: it’s a “Heads I win; tails I win” scenario. I get the premium, and occasionally get to own a stock I wanted, but at a discount.
PROBLEM: I need at least $25,000 in my account to qualify for “Level 4” trades. So far, I’m only at the 20K mark. I do have that much in my retirement account, but naked puts are not allowed there. (I’m referring to Canadian laws; don’t know the regulations in the USA.)
SOLUTION: Make a Bull Put Spread, but make the long strike far away from the short strike. The long strike then can be bought for just pennies; but it still provides modest protection in case I’ve just bought Enron. It works out to be almost the same as a naked put, but it’s allowed for just about any kind of account.
You forgot the margin amount that broker will ask you to keep. That is opportunity cost of money.
As writer said this is good strategy if you want to own the stock and you like to average down. Typically option premiums are asymmetric. Put option premiums are higher that call options because prices can fall more in given time-frame than the stock prices can go higher in the same time-frame. It is skewed distribution we all know. Hence selling put options especially when volatility is higher (stock is falling) can be sensible thing to do assuming you want to buy the stock at even lower prices. This strategy is great for value investors who want to buy already fallen stocks. For them they can buy more even if the price goes up a bit.
Hi Lee,
You neglected to mention the third possible outcome: the stock is now at $100, and on the way to even higher. I’ve lost out on the opportunity to bag a winner–which is why I wanted to buy this stock in the first place.
Bruce is correct in that when selling an out-of-the-money put, with the hope of the underlying declining to the point where he can use the put to obtain the underlying at the better strike price of his put, may not always work.
Specifically, although he banks the premium on the sale of the put no what what eventually happens to the price of the underlying, he could miss out on the ownership of the underlying if it never dips down to his put’s strike price.
That is why the white paper referred to – http://18.118.227.248/covered-call-income-more-earnings-from-stocks-you-own/ –
spells out that an investor might want to consider purchasing half of his desired amount of the underlying outright, and patiently trying to obtain the other half at the “bargain” strike price of the put he sells.
That way, if the underlying “takes off” and never reaches his put strike price, he still participates in the underlying’s gains. But if the underlying does decline enough to reach his put strike price, he gets half his stock (as well as the premium he collected up front) at a very advantageous price, and substantially reduces his average entry price on his total holdings.
how about selling a call spread and selling a put?
Just figured out my error in trying to email you from here ! My mistake.
About article, Would it be just as profitable to sell the far out of the money put and not want the stock? I am finding it hart to find verticals that work today even using the list of probable candidates for trades I received Friday. Is this a bad market for the trade method?
Thanks for listening.
Selling puts is a technique that generates income whether or not the underlying declines sufficiently to enable the investor to exercise the puts and obtain the stock at the lower price.
The key is that the investor should be happy to own the stock at the strike price of the puts he sells if the puts do go in-the-money.
The amount of premium the investor is able to collect at the option strike price chosen is a function of the option’s current volatility. As the markets are relatively low volatility at this writing, selling puts will – as always – produce premium profits, but the size of the premiums are currently a bit lower than usual.
Would I be correct that I would have to have $78,500 in cash in my account ($80K – $1,500 premium collected) or some percentage of that amount, that my broker would put a hold on anticipating that I would have to buy at $80 if the holder exercised and I was assigned, with the potential risk that the stock (not likely) could go to zero.
Txs (Enjoy the simplicity of your tip reports)
Douglas Nicholson
You are correct. When you are short a “naked” put, you can be assigned and thus the brokerage firm will require that you have sufficient funds in your account to be able to buy the stock. Of course, you could then simply sell the newly acquired shares either at a profit or a loss – depending on market action subsequent to your purchase.