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In-the-Money Options: Make Mondays Your Discount Stock-Buying Day
by Lee Lowell, Stock and Commodity Option Expert
Tuesday, March 7, 2006: Issue #289
A good option investor never pays full price for a stock. That’s why some of the best options players – yes, even Warren Buffett – know how to use options to their advantage.
I’m a big proponent of selling out of the money (OTM) put options as a way to buy a favorite stock below current market prices. It’s a strategy that lets you get paid the option “premium” upfront while you wait to see if you’re assigned on your put contracts. This is a great way to gain income as an option seller, and it also gives you the opportunity to buy a great stock that you like.
But there’s one drawback: By selling OTM puts, you may forfeit the chance to get the shares. That’s because the stock may not drop below the strike price. If you want to focus just on income, this strategy is useful. But if you really want to own the stock, in-the-money options are a better way to go about it…
Investor’s Advantage: In the Money Puts Options Get You “In the Stock”
So, let’s deviate a bit from the OTM strategy. I’m going to show you how to sell in-the-money (ITM) put options, which can almost assure that you will be assigned the shares of stock.
The transfer, or “assignment” of put options into stock shares, occurs on the Monday after options expire. If your short put options are still In-the-Money at option expiration, the buyer will exercise his long put options against you, and you will be required to fulfill your obligation of buying the stock at the stated strike price. This is a good thing if you want to own the stock.
How to Buy Your Stock Below “Book Value”
Below is a current option chain for Yahoo! (Nasdaq: YHOO) at the close on February 28, 2006. An In-the-Money put option has a strike price above the current price of the stock. So, all strikes from $32.50 and higher are In-the-Money.
If we sell the $35 In-the-Money strike put option for $3.50 (splitting bid/ask), we’re almost assured of being assigned the put options. This means that we will be forced to buy 100 shares of YHOO at $35/share if YHOO ends up below $35/share on options expiration day.
Why would we want to buy YHOO at $35 when it’s trading at $32.05 today? Because you’re getting $3.50 per option contract up front, which lowers your cost basis to $31.50/share ($35 strike price – $3.50 = $31.50). So as of today, you’d actually be buying shares 56 cents lower than their trading price now.
How To Go Deeper In-the-Money Using Options
As long as YHOO stays below $35 through the April 2006 option expiration, you can count on being assigned the shares below “book value.” That’s because you’d be buying 100 shares of YHOO at $31.50/share cost basis. The other great thing about this trade is that you get the $350 up front to deposit in your account, which will start to earn interest (not all brokers pay interest).
You can choose any in-the-money option strike you want. If you go deeper in the money, you will get more of a return upfront. But your cost basis will be closer to the current price of the stock. If you sell the $45 put, you will get $1,290 deposited into your account. But your cost basis as of today would put you at $32.10 ($45 – $12.90 = $32.10). That’s higher than the current price of YHOO. I like to stick to strikes that at least allow me to buy the stock lower than the price at which it’s currently trading.
Good Trading,
Lee
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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. 
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