Never Buy a Stock the Same Way Again

selling-puts-as-a-way-to-buy-stock

I rarely buy a stock or ETF at its current price. Why would I? Selling puts is a much better alternative.

If I’m truly interested in buying a security, I typically have a price target below the current price of the stock. Most investors just set a buy limit at their price target and hope they get shares at their chosen price. But that approach is short-sighted and, well, uninformed.

Because there is a much better alternative.

An alternative strategy that allows investors to collect premium while waiting for the stock to hit their price. That’s right, let me say it again, investors can essentially produce income while waiting for a stock to hit their chosen price. And the premium produced can be used as a potential source of income or to simply lower the cost basis of the stock they want to buy.

Why would you ever approach buying stocks any other way?

For instance, let’s say you are interested in buying Walmart (WMT), but not at the current price of 140.28.

You prefer to buy WMT for 138.

Now, most investors, would simply set a buy limit at 138 and move on, right? But that approach is archaic. Because you can sell one put for every 100 shares of WMT and essentially create your own return on capital (depending on the strike you choose). Some say, it’s like creating your own dividend and in a way, I kind of agree.

A short put, or selling puts, is a bullish options strategy with undefined risk and limited profit potential. Short puts have the same risk and reward as a covered call. Shorting or selling a put means you are promising to buy a stock at the put strike of your choice. In our example, that’s the 138 strike.

If you look at the options chains for WMT below you will quicky notice that for every 100 WMT shares we want to purchase at 138, we are able to bring in roughly $1.67 or $167 per put contract sold, every 30 days.

selling-puts-using-WMT-options-chain-august-2021

The trade itself is simple: Sell to open August 6, 2021 WMT 138 puts for a limit price of $1.67.

Quick note: when selling options, set your limit price just under the mid-price of the bid-ask spread. In the example above the bid-ask price of the 138 strike is 1.65 to 1.72. The mid-price is between 1.68 and 1.69, so selling the 138 puts for $1.67 seems reasonable. By not selling at the bid we are saving $0.02. Doesn’t seem like a lot, but when you start to add up $0.02 to $0.05 for each trade you place, well, it doesn’t take long to realize the impact over the long term. So, the lesson here is never sell at the market price. Again, using this approach will create significant returns over the long term that you would otherwise forfeit. Trade intelligently!

So, by selling the 138 puts options in August, you can again, bring in $167 per put contract, for a return of 1.2% over 30 days. That’s $2,004 or 14.5% annually. You can use the premium collected from selling the 138 puts either as a source of income or to lower your cost basis.

Just think about that for a second.

You want to buy WMT at 138. It’s currently trading for 140.28. By selling puts at the 138 strike you can lower your cost basis to 136.33.  That’s 2.8% below where the stock is currently trading. And you can continue to sell puts over and over, lowering your cost basis even further, until your price target is hit.

Or, like most investors, you could just sit idly by and wait for WMT to hit your target price of 138. Losing out on all that opportunity cost.

In review, by selling puts at the 138 strike we receive $167 in cash. The maximum reward is the $167 per put contract sold. The maximum risk is that the short 138 put is assigned and you have to buy the stock for 138 per share. But, you still get to keep $167 collected at the start of the trade, so the actual cost basis of the WMT position is 138 – $1.67 = $136.33 per share. The $136.33 is our breakeven point. A move below that level and the position would begin to take a loss.

But remember, most investors would have purchased the stock at its current price, unaware there was a better way to buy a security. We rarely take that approach. We know better. We understand we can purchase stocks at our own stated price and collect cash until our price target is hit. It’s a no-brainer.

As always, if you have any questions, please feel free to email me. And if you want further instruction on how I use the strategy, check out my approach to selling puts.

2 comments on “Never Buy a Stock the Same Way Again

  1. Tyson Miller on

    Like anything in the markets, it is a two way street. I will preface with, I like selling puts on stocks I would be OK owning at the strike price. However, it is not always that clear cut. Using your Walmart example, lets say I sell the 138 Put for $1 and a month later, it expires worthless. But now Walmart went up further and it is trading at 144. So you say, I still want to own Walmart and I am OK at 142 (or the lowest strike where you can get enough premium to make it worth it). Sell it for $1 and again, this one expires worthless and stock is now at 146. So I then sell the 144 under the same theory for another $1.
    This time, stock has a pullback to 141. So I own the stock at 146, and it is trading at 141 and I collected $3 in premium, so my cost bases 143. I am now down $2, where if I had just bought the stock at when it was at $140, I would still be up $1.
    Just a thought. Again, I like the strategy, but in a melt up market like we have today, chasing a stock up with Puts can create a loss compared to just buying the stock. Everything is a trade off.

    Reply
  2. Andy Crowder on

    Thanks Tyson. I understand your premise and the fact that anything can happen. However, what you haven’t mentioned is the probabilities on the trade placed (selling puts) and why you are using the strategy to begin with, right? If we are looking for immediate, short-term growth, we would be better served using a more appropriate strategy, one that is far more applicable to that type of stance.

    However, we are simply attempting to buy a stock and are willing to lower our cost basis while doing so as we wish to hold it for the long-term and possibly even use a premium wheel options strategy.

    But back to the probabilities, yes, there are trade offs, but again, we are selling puts with roughly an 80% probability of success, so with sound risk management in place we should be able to overcome any trade offs that present themselves over time (occurrences) due to the law of large numbers.

    Hope this helps and thanks for the comment.

    Reply

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