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.
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.