Sounds kind of backward, right? How could you get paid for not buying a stock?
Here’s the strategy, sell an option. I probably just lost a bunch of people who may have clicked on this to see what it was about. Most people hear options and run away. I look at them as another tool in the toolbox.
What is an option?
I guess the first thing to discuss here is what is an option? Here’s the short answer. It’s a contract for a specific amount of time, based on a specific stock. The longer answer is that options are financial instruments (assets that can be traded) that are derivatives (derives its value from) of other securities.
The term option is just what it says it gives the buyer an option to do something. There are two basic types of options, calls, and puts.
What are Call Options?
Call options give the holder the option to buy a specific security as a stated price (called the strike price) for a given period of time. In the case of the investor who bought a call, he has the right, or option to purchase the stock written in the contract for the price specified in the contract up to the expiration date of the contract.
Why would someone do that? In this case, the investor is hoping the stock rises above the price in his contract, known as the strike price. If it does, the investor has the option to purchase the stock at the strike price, which would be at a discount to the current market price. As the stock rises above a strike price in a call option the value goes up, so the investor could also sell the option that was purchased for a gain.
Here’s an example of a call option. Let’s say XYZ company is trading at $50. You could potentially purchase a call for $3 with the strike price of $52. Assuming the stock increases in value during the given period of time and surpasses $52 the call option will increase in value. If the stock were to increase to say $58 the call may increase from $3 to $7 or $8. The call holder could then sell the contract for a gain.
What are Put Options?
The second basic type of option is a put. Think of this as the opposite of a call option. Put options give the holder the option to sell or “put” the stock at a stated price for a given period of time. In the case of an investor who buys a put, he has the right to sell the stock at the strike price during the length of the contract.
Why would someone buy a put? In this case, the investor could be anticipating a downward movement in the stock price and wants to hedge against his holdings, or in some cases an investor could buy a put on a security and as that security declines the value of the put increases.
What’s the Strategy?
Some of you may have heard of covered calls. This is when you own a stock and sell an option to collect an extra premium. Why do some people do this? Sometimes they do it to add a little extra income to their portfolio, sometimes they are doing it to get a little extra premium when they are ready to sell their stock. Some people do the same thing with puts, which is like the opposite of the covered call strategy.
Selling cash secured puts can result in 2 things. First, like a covered call that you sell, it could expire worthless, which means you keep the premium and nothing else happens. The second outcome is that you could end up owning the stock that you sold the put on. First lesson to remember, don’t sell puts on a stock that you don’t want to own.
Here’s an example of how it might work. Again using XYZ company. Let’s say that it is currently trading at $50 a share. You like the company and are bullish and wouldn’t mind owning it, but you would rather stay in cash and just make a little extra income. You could sell a naked put for something like $45 and collect a premium. If the stock does not decline past $45 you keep the premium and the option expires worthless. If it does go down past $45 you end up purchasing the stock at $45 and still keep the premium. Generally, investors who are selling naked puts are trying to create more income for their portfolio.
Here are a few important factors you should know. Each option contract is for 100 shares, so if you ended up having to purchase the stock (the option you sold was exercised) you would end up purchasing 100 shares.
Don’t sell naked put options on stock you don’t want to own.
Make sure you have enough cash or margin to cover the purchase if your option is exercised.
Can you make money by not buying the stock?
I decided to give it a try so I started looking at stocks I was interested in. I kind of like Pinterest. A social media company that has had similar results to other social media companies after they go public. The initial price is high, drops way low, and then starts to climb back. Facebook and Twitter did something like that. Snapchat and Pinterest could do the same. At the time I’m writing this though Pinterest is around $20 a share.
So here’s the test. I want to see if I could make money selling puts on Pinterest without buying the stock, and if by chance I do end up having to buy the stock I’m ok with that. So I’ll track what I do with each option, where the Pinterest stock price at the time I sell the put option.
I started last week on May 19th by selling a weekly put with a strike price at $18 that was going to expire a few days later on the 22nd. At the time I sold the put the stock price of Pinterest was $18.40, so I was working with about 40 cents. Pinterest is volatile so I thought there was a good chance within the next 3 days I could end up having to buy the stock. Since I wouldn’t mind owning Pinterest anyway I was ok with that.
By selling the $18.00 put contract I collected a premium of $19.32 after fees. The premium was $0.20 times 100 shares equals $20.00 less a couple of small fees for trading left me with the $19.32. The total amount of cash I had to put on hold was $1,800.00 just in case I ended up getting the stock put to me. I prefer not to use margin because I don’t like the idea of paying interest. A few days later the option expired and the stock price was still above $18 per share so it expired worthless, which means I just keep the premium and nothing else happens. The trade is closed out. I just made money not buying stock!
Here’s a way to look at the return. I needed to have $1,800 available and I ended up making $19.32. This is a 1.07% return, which doesn’t sound like much, but I earned that in just 3 days. If you annualized that return…. it doesn’t matter, that wouldn’t happen. You could do this same thing multiple times a year though. I’m going to try and do this on the monthly options for now and see how it plays out.
Now that the May monthly options have expired I set out to sell one for June. I did the trade on the 26th. Again I sold an option with the strike price of $18. The June option expires on the 19th, so since there is more time for the stock price to move there is more risk of someone exercising the option, so the premium I receive is higher. This time I received a premium of $64.32 after fees ($0.65 x 100 less $0.68 in fees and commissions). At the time of the trade Pinterest was trading at $19.15, so there was also a little more wiggle room for me to get paid without buying any stock. If it turns out that way, I’ll end up with a 3.57% return for a period of about a month. If I add that to the 1.07% earned on the first one I’ll be over 4% in just over a month. Not too bad, right?
What’s the downside?
There are a couple of downsides to this kind of trade. First, what if Pinterest tanks? The stock could go from its current price down to $10 per share and I would be obligated to buy it at $18. That’s a pretty bad result, but that’s also why I would only do this on a stock I wouldn’t mind holding for the long term. Worst case scenario, this could present itself as a tax loss harvesting opportunity, not that I would like it. I guess the worst-case scenario is that the company keeps going down to zero and goes out of business, in which case I could get stuck with a $1,800 loss.
On the other hand, there is a risk of missing out. Like I mentioned above both Facebook and Twitter had huge declines shortly after going public. Pinterest is in the same boat. A few years later though, Facebook and Twitter posted huge gains from their lows. So in the back of my mind, there is a little bit of FOMO, but I’ll be happy with the results if I just end up selling options month after month.
Adjusted Cost Basis
As of the time I’m writing this article, Pinterest has closed today’s trading at $19.80. Some of you might be thinking, why not just buy the stock and forget about it. Especially if it’s going to go up. That’s just it, I don’t know if it’s going to go up or down and I like the cash flow into my account. One way I can reconcile this is to take the current price and factor in or adjust for the premiums I collect to get what it would cost having used the income as part of the purchase funds, effectively adjusting the cost basis of my purchase. In this case, using today’s price, if I were to go ahead and make the purchase it would be like purchasing for $19.80 less the $0.64 and $0.19 I received per share already for selling the puts. Essentially taking those trades into consideration, my cost per share would be $18.97, but that’s not the plan.
I’m looking at it more this way. The only way I’ll end up purchasing the stock is if the naked put option I sold gets exercised. If that happens I’ll be obligated to purchase the stock at $18.00 per share for the contract, which will be $1,800.00. I’ve already received 2 premiums totaling $83.64 so essentially I’ll be purchasing the stock for $1,716.36 or about $17.17 per share. That’s not bad. Eventually, as I sell an option contract each month, it’s possible that the stock would essentially be free. I don’t expect this would happen. It would have to be perfect timing each and every month for a couple of years, and most of you probably already know how trying to time the market ends up. More often than not you lose. Keep in mind, I’m not trying to time the market, but just trying to make a little extra income by selling puts on stock I wouldn’t mind buying at the time I sell the put.
Disclaimer! Yeah, I thought I would add a quick one of these too. This option strategy does not make up a major part of my investments. In fact, most of my investments are in exchange-traded low-cost index funds that mirror the broad market. If you’ve heard of options before you know there is risk involved. Be smart with your money and don’t risk what you can’t afford to lose.
