After last week’s historic drubbing, I’m starting to hear several talented analysts state that they might be ready to try some bottom-feeding in this market.
Can you blame them? We’ve seen some market stalwarts get hammered over the past several months, with losses ranging between -50% to -80%.
But the interesting part within the discussions I’ve heard is that no one talks about using options to dip their toes. Most simply talk about buying a stock “at these levels.” Sadly, I think this is somewhat short-sighted, especially if you are privy to options strategies that allow you to get into a stock at the price of your choosing.
Because no one can call a bottom, or top for that matter. But we can use probabilities to our advantage and collect premium while doing so to lower the cost basis of a stock that we eventually want to own, again, at the price of our choosing.
My favorite strategy to accomplish this task is simply selling puts.
By selling puts, you are able to produce a steady stream of premium that can be used as a potential source of income or to simply lower your cost basis on the position.
I take this approach every time I wish to purchase a stock or ETF, regardless of if I am “bottom-feeding” or not. And oftentimes, once I am put shares of the stock, or in this case an ETF, I simply sell covered calls against my newly acquired shares and use the wheel approach going forward.
Let’s go over a quick example.
Let’s say you are interested in potentially buying some household names, like PayPal (PYPL), but still not at the current price of 74.21.
You prefer to buy PYPL for 60.
Now, most investors would simply set a buy limit at 60 and move on, right? But that approach is archaic. Because you can sell one put for every 100 shares of PYPL and essentially create your own return on capital (depending on the strike you choose).
Some say it’s like creating your own dividend and, in a way, I kind of agree.
A short put, or selling puts, is a bullish options strategy with undefined risk and limited profit potential. Short puts have the same risk and reward as a covered call. Shorting or selling a put means you are promising to buy a stock at the put strike of your choice. In our example, that’s the 60 strike.
If you look at the options chains for PYPL below you will quickly notice that for every 100 PYPL shares we want to purchase at 60, we are able to bring in roughly $2.55, or $255 per put contract sold, every 59 days.
The trade itself is simple: Sell to open PYPL August 19, 2022, 60 puts for a limit price of $2.55.
So, by selling the 60 put options in August, you can bring in $255 per put contract, for a return of 4.3% on a cash-secured basis over 59 days. That’s potentially $1,530, or 25.8% annually, per contract. You can use the premium collected from selling the 60 puts either as a source of income or to lower your cost basis.
Just think about that for a second.
You want to buy PYPL at 60. It’s currently trading for 74.21. By selling cash-secured puts at the 60 strike, for $2.55 you can lower your cost basis to 57.45. That’s 22.6% below where the ETF is currently trading. And you can continue to sell cash-secured puts on PYPL over and over, lowering your cost basis even further, until your price target is hit.
Or, like most investors, you could just sit idly by and wait for PYPL to hit your target price of 60–losing out on all that opportunity cost and the inflated premium that can help to provide a decent source of consistent income.
In review, by selling cash-secured puts at the 60 strike we receive $255 in cash. The maximum profit is the $255 per put contract sold. The maximum risk is that the short 60 put is assigned and you have to buy the stock for 60 per share. But you still get to keep $255 collected at the start of the trade, so the actual cost basis of the PYPL position is, again, 60 – 2.55 = 57.45 per share. The 57.45 per share is our breakeven point. A move below that level and the position would begin to take a loss.
But remember, most investors would have purchased the stock at its current price, unaware there was a better way to buy a security. We rarely take that approach. We know better. We understand we can purchase stocks at our own stated price and collect cash until our price target is hit. It’s a no-brainer.
As always, if you have any questions, please do not hesitate to email me or post a question in the comments section below. And don’t forget to sign up for my Free Newsletter for education, research and trade ideas.