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Everyone knows you’re supposed to buy low and sell high. This advice is so common and so basic – and yet, almost no one talks about how to buy low – let alone how to sell high.
Today, I’d like to discuss one simple way to guarantee that you buy at exactly the low price of your own choosing – and, even better, how you can get paid to do so.
I’m not going to discuss which stock to invest in . . . but rather, HOW to invest in the stock of your choosing in the best possible way.
What is this strategy?
Selling Put Options
Here’s how selling puts actually works – and how using this strategy can actually boost your income while you wait for the price you want to pay on a given stock.
For instance, say you are highly interested in taking part in the energy sector, more specifically the explorers. You aren’t sure about which company to choose so you’ve decided to buy the SPDR S&P Oil and Gas Explorers and Producers (NYSE: XOP).
The energy ETF is currently trading for roughly $33, but you feel the price has been beaten down enough and a bounce is looming, especially if you have long-term expectations. But rather than set a limit price $2 below the current price or $31, you’ve read that you could sell puts at your “limit price” and boost your income while you wait for the ETF to hit your price of $31.
If you would like to own for $31, you could sell front-month options premium (June) for at least $0.72, or $72 per contract. That’s a 2.3% gain over 43 days or 18.4% annually. You can use the put premium to lower the cost basis of XOP or simply use it as income . . . your choice.
A quick aside: Typically when you have a wide bid-ask spread you want to sell your option of choice halfway between the bid-ask spread. This alone will increase your return significantly over the long term.
In comparison, say you wanted to purchase the 100 shares of the ETF at $31 for a total capital outlay of $3,100. So you decide to set a limit at $31 and wait and wait for the ETF to hopefully hit your limit price.
But if you sell puts at the strike price of your own choosing – you get paid.
I am always befuddled by the fact that retail investors choose not to sell puts, particularly in this situation.
You are willing to buy the ETF at $31, so why not collect some premium and lower your cost basis even further by selling a few puts? In this case, you would sell one put at the June 31 strike because you are willing to own 100 shares of the stock at $31. Remember, one options contract equals 100 shares of stock.
So again, we could sell 1 XOP June 31 puts for roughly $0.72 or $72 per contact over the next 43 days. If XOP falls below your strike of $31 at expiration you would be assigned the stock at $31 share, 6.5% lower than the ETF’s current price of $33.16. Additionally, you can subtract your collected premium of $72 to decrease your cost basis even further. So in reality you actually own the ETF for $30.28 ($31 – $0.72) . . . a savings of 8.7% from the current price of $33.16.
And we can keep selling put options, thereby lowering our cost basis further, until the ETF hits our stated price. Again, if we did this over the course of a year we could sell puts on XOP approximately eight times for a total of $5.76.
Annualized, that is an 18.4% return on the $3,100. It would lower our cost basis from $31 to $25.24.
Now you can start to see the true power of selling put options.
To reiterate – you get paid to make a promise to buy a stock you want to own . . . AT the price you want to pay.
I have to urge caution – and point out the obvious: you would never sell puts on a stock that you didn’t want to own at that strike price. That’s how most people get in trouble – they only pay attention to the income – forgetting that they CAN and eventually will get put to the shares.
Now… knowing that you are able to lower the cost basis of a stock that you want to own anyway, why would you choose to do things differently?