Using Put Options: How to Buy Stocks at Discounted Prices Everday
by Lee Lowell, Stock and Commodity Option Specialist
Wednesday, November 25, 2009: Issue #1145
Forget Black Friday. The stock market has 3,000 items on sale – and ready to give you cash back… instantly.
Over the past few weeks, I’ve discussed how you could have sold put options to go long on gold or silver through their respective ETFs – the SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV).
However, I’m going to show you how it works equally well on regular stock options, too. And with more than 3,000 stocks that have options available to trade, you’d better believe there are plenty of opportunities for you to grab the double benefit of being able to buy stocks at a discount to the current price and also get paid.
This is something I do all the time, using put options on quality Dow Industrial and S&P 500 companies. Here’s how it works…
Why You Should Sell, Not Buy Options
When it comes to buying options, here’s the phrase that doesn’t pay: time decay.
Most buyers tend to overlook this crucial factor when they buy options contracts. That’s because while an option is in existence, it will lose a bit of its value every single day, as it heads toward expiration.
Simply put, if the stock or commodity doesn’t make the desired move in the allotted time, the option value just melts away, giving the buyer almost no chance of making money.
The facts bear this out, too. The Chicago Mercantile Exchange reports that up to 80% of out-of-the-money options will remain that way at expiration and expire worthless.
So if buyers lose out, it stands to reason that sellers profit in their place. This is the overriding reason why we like to sell out-of-the-money options. The bottom line is that our chances of profiting are greater.
Not only that… if we’re obligated to buy shares of our chosen company at options expiration, we get to buy the stock at the price we selected – one we deem extremely attractive.
Here’s how it works in reality…
The Breakdown of a Put-Sell Trade
As an example, we’ll use a trade that I initiated, it was a put-sell trade on one of the largest companies in the world – General Electric (NYSE: GE).
At the time, GE was trading near $10 per share – a level it hadn’t seen since September 1995. Feeling that potentially buying GE even lower would represent an outstanding long-term bullish trade if we got the opportunity. Specifically, we aimed to buy it at $7.50 per share.
- We sold the June 2009 $7.50 put option contract for $0.65 per contract.
- Since each option contract obligates us to buy 100 shares of stock, that’s $65. In our model portfolio, we sold 10 contracts – equivalent to 1,000 shares.
- At that point, we were obligated to buy 1,000 shares of GE at $7.50 per share if GE traded down to $7.50 by June 2009 option expiration.
- With the $0.65 per contract that the option buyer was paying, we collected a cool $650 ($0.65 multiplied by 10 contracts = $650).
So the trade was simple: We decided that we’d be happy buying GE for $7.50 per share, sold the corresponding put options at that strike price and collected “instant money.”
As long as you’re comfortable with your buy price ahead of time, you’re entering into a win-win scenario. You not only get to collect money upfront from the option buyer, but also potentially get to buy a stock at the price you want.
As you can see on the chart below, GE did dip below $7.50 (it actually traded down to $5.72), but popped back above $7.50 before expiration.
The deciding factor in whether you’ll be able to buy the stock at your price is if the stock actually closes below the strike price at which you sold the options on expiration day.
In our case, GE stayed above $7.50 by option expiration, so the option expired worthless. We would have kept the full $650 that we collected on day one of the transaction, but we opted to take the trade in a different direction…
Trade Not Working Out? No Problem… You Can Still Profit With Put Options
As with any transaction, you can always offset your position by bouncing to the opposite side. If you buy an option, you can offset it by selling it. And if you sell an option, you can offset the trade by buying the option back.
This is what we did with GE.
- When GE started to move back up towards $12 per share, we opted to buy the option back for $0.15 per contract and closed the trade.
- Remember, we sold the option for $0.65, so we locked in a $0.50 gain per contract.
- On one contract, that would be $50, but because we sold 10 contracts, it equated to a $500 gain.
There’s nothing wrong with closing out a trade before option expiration. In fact, you can close any option trade at any time you choose.
So, although we never got to buy GE at the price we wanted ($7.50 per share), we still got $500 for our trouble while the trade was active. And with a few positions open each month, we can collect a tidy sum over the course of the year, giving your account value a nice boost.
Good trading,
Lee Lowell
Related Investment U Articles:
- How to Sell Put Options and Snag the Market’s Daily Deals
- How to Buy Gold for $100… And Get $200 Back
- Put-Option Selling: Treating the Market Like Your Own Personal Costco
- Selling Your Investments: Why the Gordon Gekko Philosophy Could Lose You Money
- How to Recover When Your Option Trades Turn Against You
9 Responses to “Using Put Options: How to Buy Stocks at Discounted Prices Everyday”
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Along with Karim, Lee is one of America's leading options professionals. Over the course of a distinguished career, which includes six years in the options "trenches" as a market maker on the floor of the New York Mercantile Exchange (NYMEX), he has developed a proprietary trading method capable of enormous upside while actually reducing risk. 
Hi,
Yes, but it can’t work for investors who aren’t qualified to trade naked options. Please keep us small guys in mind when you craft your lessons.
thanks for the info.
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This trading technique sounds simple, and it probably is… Haven’t done it yet.
But Marty, I think you’re write! I just called a few brokerage firms. One needs to have Options Level 4 and at the very minimum $25K to $250K in their account to be able to execute these types of trades. I think it’s a reminder that needs to be emphasized, especially for the little guy $ to $.
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$0.65 per contract multiplied by 10 contracts is NOT $650. It’s only $6.50.
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Andy,
Each option contract has 100 shares, so that equates to:
0.65 per contract = 65 bucks (0.65 x 100) x 10 contracts = $650…
Investment U
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You have to have the cash available in your account to buy these stocks before you can sell the puts against it. At least in my case. So you’re not just getting $650 out of thin air, it’s the money you get for setting $7,500.00 aside until the option’s expiration.
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If one really wanted to own GE and it traded below the put option strike price, would it not be prudent to buy the shares as in your example, for $5.72, then close out the option trade?
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Mr. Lowell, all that you wrote is correct, but you omitted stating an important factor to most small and medium sized traders including myself — that when you sell a put option, your broker will put a “hold” in your account on the amount of money needed to purchase the underlying shares until expiration or buying back of the option. So, in your example, $7500 dollars would be tied up until the put option expired. In contrast, buying the stock at the trigger price and then selling covered calls provides more “options” to the owner, and includes the opportunity to collect dividends while holding the stock. I ask you to “flesh out” your example by adding to the description what possibilities would have existed had the trader used price triggers and covered calls.
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Dave,
Most brokers only “hold” a fraction of what the full shares will cost, not the full amount of what the shares will cost. This is the reason for margin requirements.
Thank you,
Investment U
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I understand selling the puts for $0.65 for net $650, even though the option expired worthless. So why buy them back for $0.15? Am I missing something? Doesn’t this lower your $650 net to $500? Or are you forced to close the put-sell with a put-buy?
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