After seven straight weeks of declines, the longest losing streak since 2001, the bulls finally made an appearance as the S&P 500 closed the week 6.6% higher. Yep, that’s right, 6.6% higher.
Now everyone is asking, is this beginning of a launch higher? Possibly, but no one really knows with any conviction. While crystal balls might be useful in fantasyland, they certainly aren’t useful in the world of investing … at least with any consistency.
But we do know that volatility is still heightened and many of the major indices, while off their lows year to date, are offering some potential areas to possibly start bottom-feeding.
As many of you already know, I rarely buy a stock or ETF at its current price. Why would I when I have much better alternatives to get into a position?
If I’m truly interested in buying a security I sell puts on that security with the intent of taking stock at my stated price.
I typically have a price target below the current price of the stock. Most investors just set a buy limit at their price target and hope they get shares at their chosen price. But that approach is short-sighted and, well, uninformed, especially when volatility is working in your favor.
Selling puts is alternative strategy to buying a stock outright.
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.
The strategy allows investors to collect premium while waiting for the stock to hit their price. That’s right, let me say it again, investors can produce income while waiting for a stock to hit their chosen price. The premium produced from selling puts can be used as a potential source of income or to simply lower the cost basis of the stock they want to buy.
Selling Puts in Walmart (WMT)
For instance, let’s say you are interested in buying Walmart (WMT), but not at the current price of 128.48.
The stock has been hammered as of late, dropping roughly 20% from its highs set back in late April.
You prefer to buy WMT for less. But how much less?
Let’s take a look to see what the market is offering.
WMT is currently trading for approximately 128.
Now, most investors, would either buy the stock at 128 or simply set a buy limit at a lower price and move on, right? But that approach is archaic.
Because you can sell one put for every 100 shares of WMT and essentially create your own return on capital (depending on the strike you choose). Some say it’s like creating your own dividend, but rather than waiting for a quarterly payout, we have the ability to create income every 30-45 days.
If you look at the options chains for WMT below you will quickly notice that for every 100 WMT shares we want to purchase at, say 120, we can bring in roughly $1.40 or $140 per put contract sold, every 45 days.
The trade itself is simple: Sell to open July 15, 2022, WMT 120 puts at a limit price of $1.40.
So, by selling the 120 put options in July, you can bring in $140 per put contract, for a cash-secured return of 1.1% over 45 days. That’s $1,120 or 8.8% annually. You can use the premium collected from selling the 120 puts either as a source of income or to lower your cost basis.
Just think about that for a second.
You want to buy WMT at 120. It’s currently trading for 128. By selling puts at the 120 strike you can lower your cost basis to 118.60. That’s 7.3% below where the stock is currently trading. And you can continue to sell puts 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 WMT to hit your target price of 120, losing out on all that opportunity cost.
By selling puts at the 120 strike we receive $140 in cash, immediately. The maximum return is the $140 per put contract sold. The maximum risk is that the short 120 put is assigned and you have to buy the stock for 120 per share. But, you still get to keep the $140 collected at the start of the trade, so the actual cost basis of the WMT position is 120 – 1.40, or 118.60 per share. The 118.60 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.