Limit orders have long been used to strategically acquire shares of stock at a desired price, as they give traders a great deal of control over how and when their order is filled.
Want to accumulate shares of Facebook (FB) if its current retracement descends to $40? Input a buy limit order for $40. In the event FB drops below this line in the sand, your order will be filled.
However, while the order guarantees you won’t be filled one penny above $40, it doesn’t guarantee you will buy the stock. If the stock remains above $40, your order will sit unfilled, leaving you to watch any future upside action in Facebook stock from the sidelines.
Short puts offer an intriguing alternative to placing limit orders below a current stock price. By selling a put option, traders obligate themselves to buy 100 shares of stock at the strike price if assigned.
Like a limit order, they put traders in a position to buy shares of stock at a specific price. The beauty of a short put over the limit order, however, is the ability to capture some type of profit even if the stock doesn’t fall to your desired buy price. It’s as if someone is paying you to obligate yourself to buy the stock at a discount to current prices.
If you’re already a willing buyer, the extra premium is simply icing on the cake.
Take the previously scorned and recently loved Facebook stock, for example. If you’re a willing buyer at $40, instead of placing a limit order at that threshold, how about selling an Oct 40 put option for around 75 cents?
If FB continues to slide and sits below $40 at October expiration, you will purchase shares of stock with a cost basis of $39.25 ($40 – $0.75). If Facebook stock fails to drop all the way to $40, you will not purchase shares but will pocket the 75 cents as a consolation prize.
As I see, it there are two primary differences worth noting:
First, the short put requires you to allocate capital to the positions immediately. Your broker will require you to hold aside margin (usually 15% or so of the stock price) to cover the risk of the short put option. Such is not the case with limit orders. Second, the limit order will effectively get you long shares of FB whenever it falls below the $40 level. The short 40 put only allows you to accumulate shares of Facebook stock if it sits below $40 at October expiration (unless assigned early).
If you’re an active user of limit orders, consider adding short puts to the mix to acquire some of the aforementioned benefits.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.