Reduce your Entry Price by Buying Stocks with Put Options

“You make your money when you buy”

Buy low, sell high: that’s the simple way to maximize investment returns. The hard part, of course, is being able to execute on this simple adage.

In order to actually buy low and sell high, you need to have an understanding of what price constitutes “low” and what equals “high”. An article that I’ve previously written shares tools and ways that you can value investments. These tools can help you set targets for buy low and sell high prices.

Once you’ve determined your buy and sell prices, you now have to transact using them. Let’s start with the buying part. How do you buy stocks when they are approaching your target price?

There are several ways to make purchases at advantageous prices. In a previous article, I described one method which is to use limit orders to set pre-determined purchase prices. These limit orders are set at graduated prices where you buy more as prices go down. You can also use this method to help you sell at the high (or higher) target price that you’ve determined for your investment. The following article explains that process.

Today’s article is about a second way to set yourself up for advantageous purchase prices: using put options as a way to get discounts on your purchase. Similar to using limit prices, there is also a way to use options to get higher prices when you sell — in the near future, I will write an article about using call options to get those more advantageous sell prices.

Before we get started, if you haven’t been exposed to options or have limited knowledge about them, please read the following article which provides you a quick overview on how they work.

Here’s how to use put options to get a more advantageous entry price:

• Determine the target price at which point I’d like to buy a stock
• Sell a put option with an exercise price set at the target price
• Pocket the premium. It becomes either a discount to the purchase if the put option is exercised or profit if the price never gets down to the target

Now, like any method, using options has pros and cons:

Pros:

• Selling puts pays off in two ways: if my option is exercised, I get a large discount from the current price by selling out-of-the-money puts on volatile stocks. If it doesn’t get exercised, I pocket the premium less transaction costs as profit. Based on my personal experience in the last two years, about 40% by value of my sold puts have been exercised so I’ve pocketed about 60% of the premium value
• I get the premium up front and can redeploy that capital to another purchase or earn interest on those monies

Cons:

• Selling puts requires a cash balance in your account to cover the cost of a potential exercise of the option. This means that you tie up monies that you could use elsewhere through the life of the option
• Put options are based on lot sizes of 100 shares, so you have to be interested in a meaningful amount of that stock to use this strategy
• You aren’t guaranteed to buy the stock as the stock’s price may never reach the exercise price of the option. If there is a stock that you really want, buy it with the limit-price method mentioned above

Please note that I only use the put-option method for volatile stocks that I’d like to have in my portfolio, but am not wedded to. The reason I focus on volatile stocks is that the higher volatility leads to higher premiums for options — I only sell puts with premiums that are at least 10% of the target exercise price so there is a meaningful discount to my target price. I also mostly sell out-of-the money puts so that I get an even larger discount from the current stock price if the option is exercised. This leads to a higher probability that I won’t end up buying the stock and will just end up pocketing the premium as profit.

This completes today’s post on Buying Stocks at Lower Prices with Put Options. The practical steps you can start taking from today’s post are:

• Take some time to learn about how options work and how they are priced: Like any financial instrument, they have intricacies in how they work, are priced and the valid place they can play in your portfolio. Read my article What is an Option and How are they Used in Investing which provides the basics of options as a starting point for your learning:
• Determine which stocks you’d would want to purchase using the sold put options method vs. the limit-order method: I use the sold put options method for volatile stocks that I’d like to have in my portfolio, but am not wedded to. I also sell out-of-the money puts to maximize my discount if the option is exercised.
• If and when you do add options to your investment mix, make sure to start slow with small dollar values and cap your exposure in case the option does not work out the way you want: Remember that there is a lot of leverage embedded in options which can have a large negative impact if you make a “bet” that doesn’t work out.
• Please also note that I am not a financial advisor and I am sharing what we are doing with our investment mix for information purposes only: Do your own due diligence before you make any investment decisions.

Thank you for joining me on my journey to build financial literacy for young adults and their families. Please share any comments or questions that you have in the comments section. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. Also, if there are any topics you’re interested in my broaching in future posts, please let me know. In addition to the comments section, I can be reached at [email protected].