This guest post is by Kevin, who writes financial articles for young people at 20smoney.com and owns a website on Financial Freedom. Kevin continuously explores various investment strategies at both websites.
Want to know what to do when the stocks you like are too expensive? Then read on.
Because the stock market is just that — a market — there can sometimes be a disconnect between stock performance and the performance of the underlying company or business. For example, a company might be doing quite well in terms of profitability and growth, but due to overall market weakness, the stock might be moving lower. Or perhaps, due to a huge rally, your favorite companies are a little too expensive to acquire at current prices. What should you do if you know you want to own certain companies, but the stocks of these companies are a little over-priced in your opinion?
From my point of view, you have three options. I will briefly describe the first two and go into more detail on the third, more complex strategy.
The first approach to this scenario is that you wait it out completely, be patient, and buy if and when the price moves lower. The risk is, of course, that the price never moves lower and you never end up owning the stock. As such, consider the second approach, which is to buy half or maybe a third of the position you want to buy. This allows you to participate in its upside in the near term, yet keep half or more of your powder dry for a future buying opportunity. These two approaches are pretty straightforward.
How To Buy Stocks At The Prices You Want
The third approach involves trading options. Now, before you stop reading because options are scary, let me explain that this is a super conservative strategy. If you know you want to own a stock, but only want to buy it at lower prices than for which it is currently trading, you can actually get paid to wait for a better price. Allow me to explain…
By selling a put option on your favorite stock, you can earn a premium (cash), and only be committed to buying the stock if it drops and hits your desired price. If it doesn’t drop to that price, you keep the premium. No brainer, right?
So, what is the risk? The only risk is that if the stock drops well below your desired price (strike price), you are still committed to buying it at the agreed upon price which might be higher than the price for which it is trading at the time you’re required to buy. But, if you were planning to own the stock anyways, this is still a better scenario than buying it today at an even higher price.
A Simple Example
Since options can be confusing to new investors, let’s look at a simple example. Let’s say that you want to own shares of The Digerati Life (symbol: TDL) ;). The shares are currently trading at $50 per share, a little too high in your opinion.
You decide to sell a put option (1 contract = 100 shares) for $1.00 each with a strike price of $40. The option expires a year from now. You pocket the $100 and are now obligated to buy TDL if it drops and hits $40.
The following outcomes are possible:
- If TDL stays over $40, the option will expire worthless and you keep the $100
- If TDL drops below $40, you are obligated to buy the 100 shares and you still keep the $100. This is still an acceptable outcome, since you now own a stock that you wanted to own in the first place (and at a better entry point). As I mentioned above, the only risk is that you are required to buy the stock at $40 when there is a chance that TDL might be trading below $40.
By selling the put, you are earning a return on the cash that you intend to use to buy the stock, while waiting for the stock to approach a better price.
Important Things To Remember With This Strategy
- You need to have the cash in your account for the shares you are obligated to buy at the strike price. If you are obligated to buy 100 shares at a strike price of $40, make sure you have $4,000 in cash in your discount broker account.
- Only implement this strategy if you are absolutely certain that you want to own the shares of such a company. There is a very real chance that the stock will hit the strike price and you will be forced to buy the shares.
Lastly, while this is a conservative investing strategy, trading options still involves risk. Make sure you do plenty of research and have a complete understanding of the approach before you execute it.
Copyright © 2010 The Digerati Life. All Rights Reserved.
{ 11 comments… read them below or add one }
The person who buys the put option merely has the OPTION to sell to you, they are not compelled to do so, correct? Althought about the only time when it wouldn’t make sense for them to do so would be when
1) the stock price is slightly below the option price
2) price is trending upward
3) the other party wants to retain a position in the stock
4) the comissions on selling/repurchasing would eat up any profit.
So it would be a pretty narrow range, but technically possible.
I have seen so many articles over the years mentioning the writing of an equity put as a way to enter an equity position at the price you want. For the life of me, I can never understand the allure of this strategy.
Via put-call parity, we know that selling a put and holding the strike price in cash is equivalent to buying the underlying stock and selling a call at that strike. For example, JNJ is 63 and change right now, but suppose you would really like to buy it cheap – say, at 50. You could buy 100 shares of the stock and write a 50-strike call expiring a year from now. Or you could sell a 50-strike put expiring a year from now and hold $5000 in cash in the account. They are equivalent positions. Yet the average investor is typically not interested in the former, but expresses great interest in the latter.
This makes me wonder if there is something in the human psyche that does not quite understand this strategy and thus thinks they are getting something for nothing by selling a cash-secured put.
Thanks for posting my guest article! Hope everyone enjoys it. SVB will be having a guest post up at 20smoney.com this week so be sure to check it out!
I thought you gave a great explanation of a put option. You are certainly correct, you can do good at options, but you have to make sure you have the money in your account when it come time to make the purchase.
I would suggest starting out slow on options if are curious about them. Read all the fine print in your discount brokerage agreement about them too.
I am no options expert, but I am a stock expert. Why wouldn’t you just stalk (i.e. wait patiently) the shares until they came down to your price rather than selling options with the potential of capital loss if the stock gaps down through your strike price? Wouldn’t it be more prudent risk-wise to let your capital sit and be able to move into other investments (opportunity cost) while you wait for an entry point, rather than locking yourself into that contract for year? Also, because options are derivatives shouldn’t they be used more to take advantage of the leverage that can be obtained than to be a mechanism to acquire stock at a your certain price?
The advice here is aimed at those buying individual stocks rather than indexes. A lot of us prefer indexes because they make investing so simple. It’s much easier to buy stocks at good prices when buying indexes.
All that you need to do is to adjust your stock allocation as the price of the index changes. The price is revealed in the P/E10 value (that’s the price of the index over the average of the past 10 years of earnings). An investor whose risk tolerance calls for a stock allocation of about 60 percent at times of fair-value prices should probably be going with 30 percent stocks at times of insanely high prices (like we saw from 1996 through 2008) and at 90 percent at times of insanely low prices (like we will be seeing in the years following the next price crash).
Rob
Rob & Niki:
Both of your strategies/approaches that you outline are valid. By no means am I trying to push anyone into this strategy. Instead, I’m trying to explain the strategy as one particular way of waiting for a more attractive price.
Niki, you can definitely choose to wait it out vs. selling a put. If your waiting it out doesn’t materialize, you also won’t earn a return where the put will expire and you keep the money. Again, its a trade off of risk and reward.
@Niki
Waiting a stock out instead of simple selling a put can take up a lot of your time in the day, especially if you’re waiting to reach a low on several (hundred, thousand) stocks.
Some traders buy and sell so often during the day that operating without these options would be a huge resource drain.
Well, it’s all a matter of doing what you’re comfortable with. Maybe options really do scare a lot of people away as they are not too knowledgeable about how it works (yeah, including me 😉 ). But we can always get our feet wet by trying it out… why not try out a paper trading program to see how it works without risking any funds. It’s all with play money. It’s a good idea to test an idea or strategy out before investing (with your real funds) if you aren’t really too sure how it could work. Thought I would bring up this angle.
First of all, let me apologize for the tone of my earlier comment. It looks like I came across a little combative and esoteric at the same time. Some of us don’t realize how odd some of our comments sound until we read them ourselves later. 🙂
Let me try to be practical here this time…
In general I think most people would be better served keeping things simple in life. Although the definition of a vanilla put or call is pretty simple, the different scenarios they can create can be quite complex. For example, writing a put and waiting to see if the stock drops below the strike seems simple enough, but there are actually a lot of things that could go wrong.
Take my previous example of JNJ at $63 and someone wanting to buy 100 shares at $50. One approach is to have $5,000 in cash in your brokerage account and simply wait for it to hit $50 to buy. As indicated in the article, another approach is to write (sell) a 50-strike put on JNJ that expires in one year, and then secure it with $5,000 cash in the account in case it is exercised. Note that you need to keep $5,000 in cash in your account in either case. The only advantage the put strategy has over the cash/wait strategy is that you get to keep the initial put premium. But keep in mind that for this example you would only receive $120 for the JNJ 50 Jan 2011 put, and you now have quite an obligation for that $120. Look what happens with the following three hypothetical scenarios…
Scenario #1: Suppose next week news breaks that the whole mold issue with some of JNJ’s packaging is much worse than previously thought. There has been an internal cover-up about it, lawsuits multiply, and the CEO resigns. In two days, the stock plunges to $50. Yet you feel the whole thing is probably overblown and the stock will recover over time. In short, it is exactly what you have been waiting for – a chance to get into JNJ at $50. With the cash/wait strategy, all you have to do now is use your $5,000 to buy 100 shares of JNJ at $50. With the put strategy, you now have a problem. You would like to buy the stock at $50, but you have to close out the put first. This will be a problem, because even though the put is not in-the-money, it still has one year to go and the stock is now considered very volatile. The put will probably be worth about $8 or $9 dollars. This is the price you will have to pay to buy it back so that you can purchase the stock. In other words, you would have to take a $700 or $800 loss on the put. You could balk on that and wait for a few months to buy it back, but by then JNJ could be back to 55 or 60 and you would have lost your chance to buy it cheap. This scenario illustrates volatility risk.
Scenario #2: Suppose the same thing happens but it doesn’t occur next week. Instead, it occurs about a year from now with only a week left on the option. Again, for the cash/wait strategy, one simply buys the stock at $50, although it’s been a long wait! However, for the put writer, it’s also been a long wait and now there is a big problem. The stock is right around $50 and it’s not clear whether someone will exercise it or not because you don’t know whether it will close at $50.25 on Friday or $49.75. You won’t even know that at 3PM on Friday. Hence, you feel that maybe you should buy it back to be safe. However, you find that even though it’s going to expire in just a couple of days, it’s still trading for $2. So you would have to take a heartbreaking $100 loss on the put after all this waiting. You get mad because if the stock simply stays the same for the next few days, your $100 loss would turn into a profit. You decide to wait it out. Every day that week you end up checking the stock price of JNJ about 200 times during the day, and every morning you have to get up early and see whether your broker informs you that it was already exercised. In the end, you end up wasting tons of time and stressing out over the put. Sure enough, on Thursday afternoon your boss informs you that you need to take a business trip to another city tomorrow. Now how will you handle the expiration on Friday? This scenario illustrates pin risk.
Scenario #3: Suppose the whole market slowly tanks for the next 3 months. JNJ has come down to about $55 and the put is now about $4. However, some other stocks have really come down! IBM is now at $50. What a total steal! Much better than JNJ at $55! For the cash/wait strategy, you simply change your mind and buy 100 shares of IBM for $5,000. You have that flexibility. For the put writer, you must first buy the JNJ put back for $400 in order to free up your $5,000 in cash. You either end up taking a $300 loss on something you don’t even care about (JNJ at $55) or else you have to sit there and lose out on the once in a lifetime chance to buy IBM at $50. This scenario illustrates margin risk.
There are a lot of risks with options…
There is a book on this tactic: check out this link.
It’s a good read, I’d recommend it.