Short a Put Option – You’ll Get Paid While You Wait For a Lower Stock Price
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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