How would you like to guarantee that you will purchase stock at whatever discount you want, or get paid for making the attempt?
Sound like a cannot lose situation? It certainly does!
When I was first exposed to this idea, it seemed too good to be true. A nearly magical technique for finally being able to name your price for nearly any stock or get paid for doing so.
While nothing in the stock market is a cannot lose situation, this tactic comes close and is used primarily by professional traders seeking to obtain shares at a steep discount while earning a handsome income for taking the risk of doing so.
The recent market correction and high volatility has many traders wondering if this is the right time to buy stocks.
The stock market has seemingly gone insane with massive swings and surging volatility. The sharpest multi-day decline in history was countered with one of the widest point swings in the DJIA ever!
Shares were nearly flat on the final trading day of August, but the major indexes have plunged back into correction territory on the first day of September. Midweek, shares are pushing higher once again leaving investors even more confused about what to do.
Most analysts blame weak Chinese data as the primary culprit of the most recent selling.
Two sets of key Chinese data slammed traders. The official manufacturing purchasing managers’ index (PMI) dropped to 49.7 in August from 50 in July, while the final Caixin/Markit manufacturing PMI posted at 47.3 in August, the lowest reading since March 2009.
Adding to the confusion, U.S. domestic data was feebler than expected with a lack luster July factory order report being offset by strong auto sales demand and an upward revision to durable good orders.
In addition, solid mortgage application gains with a 11.3% gain keeps the bullish fever alive.
However, the ADP employment report missed expectation slowing down the buying enthusiasm, dampening the stock positive sentiment.
The widely followed fear index known as the VIX has spiked to above $31 revealing that professional traders are actively buying insurance for their portfolios in the form of derivative contracts.
In the midst of this confusion, professional traders are quietly snapping up shares at steep discounts.
These seasoned market pros are even getting paid for setting buy orders below the already deeply discounted levels.
This very effective technique involves selling put options to “lock in” a discounted price where you want to purchase the shares.
I know some of you are afraid of selling options due to the high risk. Others are frightened by the derivative market in general. Make no mistake, in the wrong hands, options can be very dangerous to your account. However, when used prudently and with a well thought out plan, they are an explosively profitable tool in your stock trading toolkit.
Before we get into the exact tactic to earn money by purchasing stocks at a discount, let’s take a closer look at options themselves.
Understanding options is the mark of a true professional trader. There are longer term investment options known as LEAPS and short term option trading instruments known as weeklies.
Regardless of the option trading strategies that you choose to use, understand options and their benefits is a great place gain a deeper understanding of the marketplace.
Here Are Three Benefits To Using Options:
- Flexibility
This is perhaps the catch all term for options. No matter what your market opinion, there is an option and option trading strategy to employ. In fact, not matter what the market is like. Whether it is bullish, bearish or flat, there is an applicable option strategy.
- Leverage
One of the biggest complaints I hear from stock traders is that it’s too expensive to buy certain stocks. Rather than being blocked out from the market due to lack of funds, the leverage options provide allow even the smallest trader to control and benefit from expensive stocks.
If capital isn’t a problem for you, options allow you to use leverage to amplify your returns.
- Limits Risk
I know some of you are thinking, what is he talking about? I thought with all the leverage options can do nothing but create more risk. Nothing could be further from the truth. Options define and limit risk. Option buyers can only lose what they spent on the option. However, stock short sellers have unlimited upside risk since stocks can keep on climbing higher.
In addition, certain strategies such as covered calls and selling puts can be used to limit risk in an existing portfolio.
The Tactic
Ok, now that we understand the benefits of options, and hopefully alieved you of some unfounded fears, let’s drill down into how to use options to buy stocks at a discount or get paid for the attempt.
This tactic involves the selling of put options. Every put option represents 100 shares of stock. This means that for every 100 shares of stock that you want to purchase, at a certain price, you sell one put option at the strike price at the discount you want to buy the shares.
One of two things can happen.
First, the stock never drops to the strike price. If this happens, you get to keep the premium for selling the put option.
Second, the stock drops to the strike price or below. If this happens, you will be “put” to the stock. This means forced to buy the shares at the discounted level you already agreed was a great price to own the shares.
The best news here is that you get to keep the premiums earned no matter what happens. These premiums earned by selling the put will allow you to buy the stock by using even less of your own money therefore, in effect, getting an even steeper discount. This is the bad news!
Many professional traders and investors use this tactic month after month just collecting the premium and rarely being forced to buy the shares. By doing this, a steady income can be created but always with the caveat that you may have to actually purchase the shares at the price you agreed with.
Managing The Worst Case ( If you don’t want to own the stock)
Pro traders always think of the downside first. Amateurs only think about how much they can make. With this said, there is another way to handle an adverse move instead of buying the stock.
It is to buy back the put options at a loss.
The decision you make will depend on whether your bias towards the underlying stock has changed since selling the call. If your underlying thesis changes, it is often best to take the loss rather than risk owning a stock that may plunge
You should probably buy back the put options at a loss if a significant piece of bad news had surfaced which negatively impacted the fundamentals of the underlying stock, causing you to be no longer bullish on the stock. The premiums that you received will help to cushion some of the losses.
Otherwise, if the descent in stock price is minor and your target price is hit, you will be able to buy the stock at a reasonable discount along with the extra cash received from the sale of the cash covered put options.