Owning shares is a dream most people have shared at some time or other. But many people also fear the perceived risk in doing so and for this reason, hesitate. But did you know that if you understand something about options and you’re thinking of owning shares, there is a way you can use them to purchase your shares at a much cheaper price than if you just went to your broker and bought them?
Let’s take an example to illustrate how it works. We’ll use the oft quoted imaginary XYZ company for our purpose. Imagine XYZ is currently trading on your local stock exchange at $35 and you think it might be a good investment if it falls another $5 or so. You may have concluded this because you have looked at a daily price chart of the stock and notice a pattern such as a “channel” (highs and lows between two parallel lines) which leads you to believe that it won’t be long before the price will come back to say $30 in the near future.
Or you might be a short term stock trader and you’ve observed this stock’s price starting to fall in such a way that is consistent with past movements of a similar size. So you believe it is likely to reach a low of $30 sometime within the next month or so for that reason and you want to buy it when it does because that’s when you think it will turn around and head north again.
Or you just be an investor who wants to buy stocks to hold for the long term and would like to get a better deal on purchase price. If you had the nerve to take opportunity of falling stocks during the global financial crisis and wanted to snap up a bargain, this option strategy would make the deal even sweeter.
Here’s what you can do.
XYZ is trading at $35 today and you’re prepared to buy it when it reaches $30. You would need sufficient funds in your broker account to purchase at the $30 price tag to utilise this strategy. When the stock is trading at $35 or less, you would sell “out of the money” put options with an expiry date the following month and a strike price of $30. Selling option contracts is sometimes called “writing” and the process involves creating them out of nothing. This option contract with a $30 strike price means that you are willing to allow the market to “put” shares to you at that price up until the agreed option expiry date.
In consideration for this, you would receive a premium which would be credited to your account. The premium is yours to keep, no matter what happens after that. Let’s say your receive $3 for each share, which means that if your option contract covers 100 shares, you would receive $300.
After you’ve done this, one of two things can happen.
First, the share price could fall to $30 or below by the option expiry date, the options would be exercised and you would buy the shares at that price. The 100 shares of XYZ would cost you $3000 less the $300 you receive for selling the options, a total of $2700.
The alternative is, that the share price never reaches this level, in which case you simply keep the $300 you received from selling the options. Then you just go to the stock market and do it again.
But let’s say that XYZ’s stock price had fallen to $28 by the time your put option contract expired. You would have to purchase at $30 but the whole deal would still only cost you $2700 all up. If you had waited instead to buy at $28, it would’ve cost you an extra $100 so you’re still ahead.
At this point, if you still have more funds available, you could use an averaging strategy to buy more XYZ shares, but this time for say $24. Let’s say the price has fallen to $28 as above and you have purchased your 100 shares at $30 but an overall cost of only $27. You now immediately sell a further put option contract with next month’s expiry date but this time with a strike price of only $24 receiving a premium of $2.50.
If XYZ’s share price doesn’t fall as low as $24 by the new expiry date, you keep the premium and it offsets the cost of your original 100 shares – which instead of $27 have now cost you only $24.50 each. But let’s say the price fell as low as $20 by the new expiry date. You would be forced to buy the shares at $24 less your $2.50 premium for selling the options – a total cost of $21.50 per share.
You now own 100 shares costing $27 and a further 100 shares costing $21.50. That’s 200 XYZ shares at a total cost of $4850 or $24.25 per share. If you had purchased these shares without using options, just “averaging down” they would’ve cost you $5400 all up, or $27 per share when in our worst case scenario here, the price has fallen to $20.
So even when the market is taking a dive as outlined above, where the stock price has fallen over two months from $35 to only $20 – if you had sold put options as part of your strategy, you would be better off by 200 x $2.75 or $550. This is a 10 percent discount after brokerage costs.
Now that the price has fallen to $20 you simply do it again for next month and receive another premium which will offset the overall cost of your two previous purchases if the price begins to rise again. Eventually, you will own shares in your chosen company at a discounted price which in the long run will mean greater capital gains.
By: Owen Trimball
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Owen has traded options for many years and is the author of a popular blog on the subject. Visit Owen’s site to understand the advantages of Option Trading Strategies and how you can use options to buy stocks cheap