I think it is safe to say that everyone wants to buy things at a discount. I would guess that most beginning options traders feel comfortable buying stock. They feel they know stock and have owned stocks in the past. Or maybe they have bought stock through their self-directed 401(k) plan at work
This simple strategy allows you to buy stock at a discount and get paid to do it. That’s right Buying stock at a discount to its current price. Let’s see how to do it.
Let’s say you are bullish on a stock like Twitter (TWTR). The stock closed last night at $47.62. Using our metrics (covered in an earlier post), we can see it is a liquid stock at price we are willing to pay. In addition, the IVR (Implied Volitiliyt Rank is 22.5. Not ideal, but for the purposes of this discussion, it will do Remember, we want to sell options, when IVR is around 30. And it is very liquid (narrow bid/ask spread and good volume)
The first part of the strategy is to sell an out of the money (OTM) put for a credit. As we learned in another post, when we sell a put we are obligated to buy the underlying at the strike, if we are assigned the stock. For this obligation we are paid a credit.
Let’s use Twitter as an example
Let’s say we like TWTR and believe the price will go up in the next 50 days. Since selling a put is a bullish strategy and buying the stock outright at $47.62 is a bullish play, we can sell the put today at and give the owner of the stock the right to sell it to me allows us to buy the stock at a strike price we choose, we could write a $45 put out to Jan 15, 2021. We would receive a credit of $1.45 $145.00. If the price of TWTR falls to $45, we could be assigned the stock and buy it for $45.00. The current price is $47.62. And as they say, if you like it at $47.62, you must certainly like it at $458. But that isn’t all.
Because you received a credit for giving the owner of the stock the right to sell it to you at $45, you would keep the credit, which makes the cost basis of the shares $45 – 1.45 = $43.55. That’s about a 5% discount to the current price. That’s a great discount.
The other nice part of this is that if the stock does not fall in price and ends up above the 45 strike, you keep the credit. And can run the strategy all over again in the next expiration cycle
- Find a stock you would be comfortable owning today.
- Write a put at a strike well below the current price of the underlying
- Receive a credit for selling the option
- Buy the stock at the strike price, if assigned and apply the credit to the discounted price you paid to reduce the cost basis further.
- Rinse and repeat, if you do not get assigned and keep the credit.
And, there is more
So, 45 days have passed and the price of TWTR has dropped to $45 and you get assigned. You now own the stock at $45 less the credit received, when you put on the trade $45 -1.45 = $43.55. That’s great! But you are still bullish and you wanted the stock to go up, but obviously the stock went down. There many reasons why this may have occurred. There is no free lunch in the world, but you do have options with options.
Since you bought the stock at $45, if your directional bias has changed, you can turn around and sell it at the market.
You OWN the stock at $45. It’s yours to do with as you please. Since you own the stock ( you are long the stock), and you are still bullish on the stock, you could sell an out of the money (OTM) call against your position and collect additional premium, which further reduces your cost basis.
You are bullish on a stock, but would like to buy it at a price below the current price. You sell a Put option below the current price and collect a credit. If the stock falls to the price of the put, you can take the assignment and own the stock at the price you wanted, when you put on the trade.
IF, after you sold the put, the price of the stock goes up, you win. Selling puts is a bullish strategy. If the price of the stock remains above the strike price at expiration, you keep the credit you received.
To further lower the cost basis, you can sell(write) an OTM call at a higher strike price and collect additional credit. This further lowers the cost basis of your shares. If the price rises to your new call strike, you may be called away at the higher price. You were bullish and the stock did what you wanted it to do.
Check out the next post for more covered call examples!!!
Please share your thoughts and suggestions in the comment section below