Become a better investor using stock options
So you've done all your due diligence and analysis and you've found a public company that you would like to invest in. If you're like most of the retail traders out there, you simply go out and start buying stock out on the market at an acceptable price level.
But if you're going to do that, why don't you pick up some premium?
We're going to discuss one of the best techniques for an investor to acquire the shares of a company: Naked Puts
What this means is that you acquire stock by writing a put. This leaves you "naked," which means that you are under obligation to come up with the money to buy 100 shares of stock at a certain price. But that's what you wanted to do in the first place, right?
The first concern that you may have is that this strategy is known as "risky." But let's see what that actually means. Generally, if you sell a front month ATM (at-the-money) put, your delta exposure is around .40-.50. That means for every point move in the underlying stock, your contract value changes by $40-50. If you were planning to buy 100 shares of the stock in the first place, your delta exposure is half if you were in a naked put position. This means that your risk is cut in half, so if the stock goes against you, it does so with half the consequences.
But the real reason you write a put is the premium that you collect that will reduce your basis in the stock. With a month left, you can collect 3-5% return on basis for index funds, and 4-7% return on single stocks. This gives you a tremendous advantage in the long run.
Let's look at a real world example. This example was taken on Sept 29, 2008. It is an AAPL option chain.
This was taken after market and during a significant drop in price. This is used as an example only and by no means is a trade recommendation. This particular example is interesting because it comes in a time of extreme market volatility. We're assuming that the hypothetical investor thinks that acquiring AAPL at $100 a share is a good idea. Instead of going outright and acquiring the stock, he can sell a front month 100 put for about 8.20. Let's see what kind of return that gives us.
$100 Collateral needed - 8.20 premium = 91.8 basis
8.20 Maximum gain / 91.8 basis = 8.9% return
This gives us 8.9% return on basis in 18 days. That's a significant edge, especially if you think buying AAPL at 100 a share is a good idea.
Here is what the risk profile looks like:
Managing this position can become very interesting. Ideally, this position is slightly bullish. You aren't expecting a large move. But if a large move happens to the upside, the put loses value and the investor can choose to either roll to a new strike to maximize their premium potential, or they can take the gain off the table and eliminate risk completely. You could even try and reenter the position at a more favorable price.
If the position moves to the downside, that is acceptable to the investor because he or she was comfortable enough to buy shares at that price anyways. If the put is exercised against them, they buy at that strike and then they can comfortably move to a covered call or a stock collar (strategies discussed in a different post).
This example can be replicated with any security that has options available for it. If you do plan on getting long stock, you should definitely have this strategy in your arsenal.
We hope that this tutorial helps you to become a better investor and trader. If you'd like to gain even more of an edge, you can become an IWO member. Receive videos filled with trading ideas and market commentary. Click here to become a member!