“I’ll buy it when it’s a little cheaper.”
It’s a common statement made by investors. Unfortunately, for those on the fence about buying shares, that day rarely comes. When a stock does get cheap enough, markets may be in selloff mode, and then the potential buyer still sits on the sidelines.
But there’s a way that allows investors to potentially buy shares at a price they like in advance. And unlike a limit order, this strategy uses the options market so that you get paid for taking on the “risk” of buying a company you like at a reasonable price.
The trade? It’s called a put sale.
The concept sounds a little weird at first. But all that happens is you’re committing to buy shares of a specific company at a specific price on a specific date.
The put sale strategy at work
Say you’re looking to buy shares of The Walt Disney Company (DIS). They’re currently around $115, but you don’t want to pay more than $110 per share.
Looking at the options market, you could sell to open October $110 puts. The ticker symbol is DIS201016P00110000.
“DIS” is for the underlying shares, the “201016” is the October 16, 2020, the strike date of the option. The “P” shows it’s a put, and the 00110000 shows the strike price of $110.00.
Let’s say you sell to open. The option recently traded for $4.60. In that case, $460 (the $4.60 times 100 shares that each option contract is for) is deposited in your account.
Fast forward to October. If shares are over $110, you won’t get “put” shares, and you keep the $460. If shares are under $110, you’re required to buy 100 shares at $110 for each contract. You also get to keep the $460.
Do a little math, and that really means you’re buying shares for $105.40. Not bad considering you didn’t want to pay over $110!
However, this strategy isn’t perfect. No matter how low Disney shares sell for, you’re on the hook to buy them at $110. If shares dropped to $75, you’d be assigned shares at $110. Even with the put sale premium, you’d still be in the hole.
Conversely, if shares of Disney never drop below $110, you’ll never get into shares of a company you want to own.
Of course, as one put sale expires, you’re free to sell another one.
Theoretically, you could repeat this income-producing exercise a few times a year without ever owning shares. Doing so, you’d earn a greater income than buying shares and receiving a dividend, but you’d miss out on capital gains.
There’s a big caveat, however, with this strategy. And that’s how much money you have. At $110 per share, a single contract for 100 Disney shares comes to a cash balance of $11,000 that may be needed if shares are put.
You can use a lower amount if you have a margin account, but employing a number of put sales in your portfolio at once could be a problem in a fast market selloff like the one back in March.
Still, for generating more income off of a stock investment, a put sale strategy is a way to go. Once assigned shares, a trader can turn around and sell covered call options to earn even more income off of a trade.
That’s not a bad combination for generating returns that can beat the market, even with low-volatility stocks.