by John Jagerson | October 16, 2009 2:45 pm
This options trading article is brought to you by LearningMarkets.com.
Option traders have an advantage over stock traders because, when the timing is right, they can buy stocks at a discount. How do they do it? They sell put options on stocks they want to own and then wait for the price to fall. Sound complicated?
Surprisingly, it’s quite simple once you understand the basics. Let’s start from the top and take a look at the first step you need to take to start putting this strategy to use in your own portfolio.
Step 1: Find a Stock You Want to Own
The first step to take when looking to buy stocks by selling puts is to find a stock that you would like to own. After all, in the end when you employ this strategy, you are hoping to own the stock as a part of your portfolio. And since you wouldn’t just go out and buy any old stock in a standard stock trade, you shouldn’t just settle for any old stock when implementing this strategy.
This may seem obvious, but when we get into the next step, you will see that if you don’t start with Step 1, it is easy to be tempted to simply sell puts on the stocks that are offering the highest premium–which can be a big mistake.
When you’re looking for stocks you would like to own, make sure you look for stocks with strong fundamentals–especially in turbulent markets because they have a good chance of rebounding faster than other stocks.
Step 2: Sell Put Options
Your next step to buying stocks at a discount is identifying which put option you are going to sell and then selling it. As an option seller, you have three choices when looking at which put option to sell. You can sell the at-the-money option, an out-of-the money option or an in-the-money option.
When selling puts to buy stocks, you are typically going to use an at-the-money put option. At-the-money options offer a nice balance between paying a good premium and giving you a good chance of actually having the stock put to you.
The premium you receive for selling the put option directly impacts the discount you will get on your stock purchase if the stock is put to you. The higher the premium, the better the discount. As I mentioned above, some stocks offer extremely high premiums on their put options either because the stocks are extremely volatile or everybody believes the stock is going to be moving lower. If you haven’t done your homework and determined that the stock is one you would want to own, you may be tempted to go for the stock with the highest premium.
Step 3: Manage Your Trade
Once you have sold your put option, it is time to sit back and see what happens to the price of the stock. Basically, one of the following four things can happen to the price of the stock:
– The stock price can go up
– The stock price can stay where it is
– The stock price can go down a little
– The stock price can down a lot
Let’s take a look at what would happen in each scenario.
The Stock Price Goes Up — If the stock price goes up after you sell the put option, you don’t have to do anything. The put you sold will expire worthless, and you get to keep the premium you received when you sold the put.
The Stock Price Stays Where It Is — If the stock price goes up after you sell the put option, you don’t have to do anything. The put you sold will expire worthless, and you get to keep the premium you received when you sold the put.
The Stock Price Goes Down a Little — If the stock price goes down a little, the person who bought the put from you may choose to exercise the option, and you will have to buy the stock at the strike price set in the option. But since you sold the put on a stock you wanted to own anyway, this is a terrific result. You now own the stock you wanted, plus, you get to keep the premium you received when you sold the put.
The Stock Price Goes Down A Lot — If the stock price goes down a lot (below your breakeven point), the person who bought the put from you will definitely choose to exercise the option, and you will have to buy the stock at the strike price set in the option. But once again, since you sold the put on a stock you wanted to own anyway, this is a terrific result. You now own the stock you wanted, plus, you get to keep the premium you received when you sold the put.
Of course, if you see the stock dropping below your breakeven point, and you decide you don’t want to buy the stock after all, you can always buy back the put you sold and exit the trade.
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