Let’s assume that you have determined the price you are willing to pay for a particular stock or a stock index. And let’s also assume that you are not willing to pay more than what you determined to be a fair price.
Let me share a way that sophisticated investors buy stock.
A good way to describe this strategy is to use an example:
Let’s assume your account is currently 100% in cash and the S&P 500 index is currently trading at 4,000, but you don’t want to buy at the current level, you believe the market is overvalued and will only buy if the market is at or below 3,600 (10% lower than the current price).
There are a couple of strategies you can employ:
First option: If you are willing to wait, you could just hope that the stock market falls to 3,600 and then place your order. If the stock market never drops to 3,600, your account will remain in cash. - This is the non-sophisticated way.
Second option: You could sell a Put Option. By selling a Put Option, you will collect what’s called the option premium. - This is the sophisticated way.
So how does this work?
For example, you could sell a 1, 3, 6, or 9-month 3,600 Put Option on the S&P 500 index and receive a credit in your account immediately.
There are 3 things that can happen at expiration of the Put Option that you sold.
If the stock market remains above 3,600 at expiration, you can roll into another option position to collection premium once again. You can continue to do this as long as you'd like or until you end up purchasing the shares. To add another level of sophistication to this strategy and increase your returns even further, you can purchase US Treasuries (instead of holding cash in your account) to support the Put Option position to generate additional returns.
In a nutshell, if you are going to buy the index when it hits 3,600 anyway, why wouldn't you pick up an additional few percentage points in a relatively short period of time by using this strategy? On a side note, this strategy typically pays out more when it's employed to purchase individual securities.
There is almost an infinite number of ways to implement this strategy, as you can change the expiration date and/or the price you are willing to pay, which is called the strike price. In other words, your premium amount could be substantially more or less depending on these factors (and others). To corroborate this strategy, Microsoft and other companies in the 1990's executed this strategy for several years and made hundreds of millions of dollars. In some quarters, Dell Computer made more money selling put options than selling computers. Click here for learn more about how options are valued.
This strategy is typically reserved for sophisticated investors who understand the nuances of stock and index options. However, if you do understand them, it can feel like you took the red pill from the movie The Matrix.
It can pay to know your options.
-Paul R. Rossi, CFA
Important Note: Options should only be used by investors who know and understand the risks involved. Options are complex financial instruments. The value of option contracts are based upon many factors that need to be understood before buying or selling options.
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