Disclaimer: option trading can be conservative or risky – it pays to take some time and educate yourself. A great start would be to check out Mark Wolfinger’s “The Rookie’s Guide to Options” before getting started with option trading.
Have you ever had your eye on a stock and thought to yourself, “I’d like to buy it if it becomes cheaper”? Some people may decide to enter in a limit order to buy the stock for 5% or 10% below what it is currently trading at. For example, stock XYZ is trading at $50/share and you would like to buy 100 shares for $45/share. You could just enter in an order to purchase 100 shares with a limit order of $45/share. If the stock never dips down to $45/share, your order goes unfilled and you aren’t out any money. But if it does go down to $45 (or lower) then your order gets executed. Many people put in “stink” bids on stocks all the time, knowing full well their orders may never get executed and some may get filled at what they perceive to be great bargains.
An Alternative: Writing a Put
Another way of accomplishing essentially the same thing (and perhaps with an advantage) is to write a put option on that stock with a strike price of $45/share. A “put option” is a contract that gives the holder the right to sell a stock for the strike price indicated for as long as the contract is in force (the “term”). These contracts have value, and by “writing” a put contract you are SELLING someone else this contract. This contract holder will have the right to sell their stock and you must agree to purchase it at the strike price.
So let’s go back to our example. Stock XYZ is trading at $50/share and you would love to be able to buy it for $45/share. Instead of placing a stink bid for $45/share, you sell someone a put option on the stock with a strike price of $45/share (1 contract is for 100 shares) and a term of 6 months. You sell this contract for $1.50/share (or $150 total for one contract). No matter what happens, this $150 is yours to keep. If in the next 6 months, stock XYZ never makes it down to $45/share the option holder won’t have any reason to force a sale of XYZ to you at $45 and the contract will expire worthless. If you still wanted to potentially buy it for $45/share, you could just turn around and sell another contract and collect the premium again.
If XYZ does make it down to $45/share (or lower), then the option holder may exercise their option to sell the stock to you at $45/share. So what has happened? The stock that you were willing to purchase for $45/share is yours for $45/share plus you pocketed $1.50 share extra. So really the cost is more like $43.50/share.
Disadvantages
If XYZ completely takes off, you would miss out on the potential gains if it never made it down to $45/share.
If XYZ drops like a stone quickly, you could be forced to buy it for $45/share when it could’ve gone down as low as $35/share (but if you had a stink bid in, it would’ve been subject to the same problem).
Conclusion
What’s been described definitely is riskier if you don’t have the cash in your account to buy the shares if the stock is “put to you”. Having the cash makes this “writing a cash-secured naked put”. Naked means you don’t have an offsetting short position in this stock at the time of writing the put. This is dangerous when you don’t have the cash to make the purchase (although many discount brokerages don’t allow writing of puts if you don’t have the cash to secure it in the account).
Having said that, for people who are used to placing limit orders for securities at a significant discount to the market price, you may well want to look more into writing a put instead. It’s not unheard of for people to continuously write puts against a stock, not have the stock get put to them, and just pocketing the premiums over and over.
Like always, this is a strategy that can work great…until it doesn’t. I think the key is to be doing this with a stock that you’re okay going long on if it tanks. So, people who do this with SPY, hoping to just continually pocket the premium, are probably happy to be forced to buy it if the stock tanks and change to a long position because SPY is expected to go up eventually. However, if you do this with something like C, which on the face seems just as safe as SPY (of course, it’s nowhere close), but if C tanks, it may never recover (because in order for C to tank, something really bad has to happen to the company).
Best when used with stocks you want to buy and this is a good strategy for investors who want to accumulate stocks.
This strategy could go hand in hand with covered call writing. Let’s say your strike price is hit and you buy the stock. The very next day write a call option with a strike price of $50/share. Of course, the most important part is to actually own the underlying shares.
Speaking from experience, there’s nothing worse than getting ready to sell your first put just to find out that your brokerage account doesn’t let you do this.
Make sure that your account has sufficient access to be able to sell puts. If you don’t have the cash sitting in the account you may also want to see if you can sell uncovered puts if you want to purchase the underlying shares on margin.
In your Disadvantages section, you’re comparing put-writing with buying the stock outright, but they’re not really comparable, because if you think the stock is worth buying at the present price, you just buy it (or buy deep-in-the-money call options I guess).
The better comparison is against a limit buy order. Compared with that, writing puts has pretty much no disadvantages, except that you’re forced to buy in lots of 100 shares.
@Patrick – I would write deep ITM puts instead of buying deep ITM call options, and I did in fact compare put writing with a limit buy (stink bid).
@Preet – Ok ok, so I only just learned what a DITM call was a few days ago in a book, and I said it to try to sound smart. Thanks for ruining the illusion. :-)
What do you think of buying a stock vs. writing DITM puts?
I agree, but really the most important thing is experience with both.
Can you buy and sell options on ETFs, for example XIU? Thanks.
@ Deb: Yes you can. There are about 10 canadian listed ETFs you can purchase options on, but you want to make a note of the liquidity of each. For example, the market for HXU and HXD options are thin, but XIU is more healthy – but not as good as US listed ETFs.
Writing puts on an ETF. Interesting. Doesn’t this amount to a derivative of a derivative? I’m leery of ETFs in the first place. I don’t think their advantages (market pricing, low MERs) outweigh the disadvantages (trading commissions) for the average DIY investor.
Also for thinly traded ETFs, a sizable spread can develop between the market price of the ETF and the NAV.
@Cash Canuck – an ETF is not a derivative, but your point is well taken with respect to premiums and discounts of thinly traded ETFs. I’m curious though, as to what you recommend for the average DIY investor if not ETFs?
I think an equivalent index mutual fund would be appropriate. Something like TD e-series funds (up to 0.5% MER). iShares CDN equity comes in at 0.25%. I think the difference in MER would be made up for by saving the trading commissions. Caveat, as you increase the dollar amount invested, this situation shifts in favour of ETFs. Furthermore, holding a mutual fund as opposed to a market-traded security discourages more frequent trading. With a mutual fund there are no bid-ask spreads and none of the behind-the-scenes arbitrage that come with ETFs.
Woo! How’s that for off-topic? Aren’t we supposed to talk about options? I love this type of discussion, though. Great blog!