In the roughly two decades I have spent observing, studying, and participating in stock and option trading and investing, I have become convinced of two things:
- Serious, committed, and relatively successful long-term investors tend to do best when getting involved with options.
- Serious, committed, and relatively successful long-term investors absolutely should incorporate options into their long-term portfolios.
Some associate options with short-term, speculative trading only. Well, there’s certainly nothing wrong with short-term and (depending on how you define it) speculative trading, this stereotype often scares people away from options. We have all heard stock investors say something to the effect of I’ll never mess with options! That’s fine, but why close yourself off to the possibility of increasing your returns with very little additional risk? And what better way to introduce investors to options than with basic and, while not risk-free, relatively tame strategies.
In this article, I explore my favorite way to use options, logically, inside a long-term portfolio.
Put selling is my favorite options strategy for the long-term investor. Note that when I refer to “long-term” I mean nothing less than five years, but something closer to 10, 20, or 30 years.
Think of a company you love- one that you would like to own for a long time at any price. In particular, this is a stock you would absolutely love to buy on a pullback. At the same time, you would also buy it for a few dollars more than your current average because, over the long-term, you think it’s going to keep going up. Not only do you desire or would you be okay with these things, but you have plans to buy more of this stock. If this describes your situation, selling puts could work as at least part of your buying strategy.
When you sell a put, you’re employing a bullish strategy. That’s because you’re giving yourself the right to buy a stock at a price below its current market value. You’re bullish in this context because you’re fine with buying the stock at a price lower than its current market value or you don’t think the stock will drop and simply want to bank the premium you receive for selling the put.
Here is an example of what I’m talking about: A stock you own presently trades for $120 a share. You are in at an average of $116.50. You want to buy several hundred shares more. You like the stock so much you would buy it at a price lower or higher than you average again and again.
To buy 100 of those additional several hundred shares outright will cost you $12,000. That, or dollar-cost averaging into more shares of the stock is a perfectly viable and traditional way to build a long-term position. However, selling a put to potentially get into the stock at a cheaper price adds a layer of sophistication that can reap additional rewards.
Let’s say you sell one August $115 put option that expires one year from now. And let’s estimate that you receive a premium of $5.50 for selling that put. You’ll collect $550 in premium on the trade. You also agree to buy 100 shares of the stock at $115 no later than next August. If the stock drops to $115, you’ll buy 100 shares at that price, less the $5.50 premium you received, bringing your actual cost per share to $109.50.
Of course, you’ll need the buying power necessary to execute the trade if the shares end up getting put to you. Along those lines, you’re dealing with time, in that you have tied up present/future buying power to cover the potential purchase of this stock at $115 at some point going forward. Obviously, you’ll need a pretty well-rounded portfolio with sufficient cash for this type of approach to make sense for you.
If the shares do not drop to $115, the option expires worthless, you keep the premium and move on. You can go ahead, if you already haven’t with other funds, and buy more of the stock at a slightly less attractive price. Because remember your mindset — $115, $120, $125 — it doesn’t matter to you. You’re going to still own this thing when you’re sixty.
Say you really want to make sure you get more shares of the stock at a slightly lower price than what the stock is trading at now. You don’t think or you don’t want to take the chance that the stock will go from $120 to $115. In this case, you could still invoke the same strategy, just using a put option that is closer to being in the money or is even slightly in the options.
For example, you could look a few months out to November of this year and with your stock trading just above $120 (say, $120.65), you could sell the November $120 put and receive, let’s call it, $3.45 in premium. This means you’ll receive $345 and have to buy 100 shares of the stock for each put you sold at $120 if the stock hits that level between now and November. But, because you took in the $3.45 premium, you would effectively be paying $116.55 per share.
With this strategy, you’re literally getting paid to buy a stock you would love to own at a lower price. Your main risk is that the stock will not drop that much resulting in you keeping the premium and raising the price you’ll have to pay if you still choose to buy more shares.
Remember, this is a stock you love so much and intend to hold for so long that a few dollars per share here or there means little to you.