How To Invest

Put options explained: How to earn income while waiting for the right stock price

Are you tired of waiting for the perfect moment to buy your favourite stocks at a lower price? Or maybe you’re seeking smarter ways to reduce your entry cost? Enter put options — a strategy that allows you to earn income while you wait. Though put options might seem complicated initially, once you grasp their basics, they can become a valuable addition to your investing toolkit.

Understanding put options

A put option is a financial contract that gives the holder the option, but not the obligation, to sell a stock at a specified price (the strike price) by a specific date (the expiration date). While this might sound complex, let’s break it down into simpler terms.

The main benefit of put options is that they allow investors to profit from falling stock prices or protect their existing investments. For example: Imagine you buy a put option with a strike price of $50 that expires next month. This means you (now the option holder) have the right to sell the stock at $50 any time before or on the expiration date. If the stock’s market price falls below $50, you can still sell it for $50. It’s like having insurance for your stock — you’re locking in a selling price by purchasing the put option, even if the stock’s market value drops below that price.

How to use put options for income

One of the key features of options is that they allow investors to be either buyers or sellers of the options. As a put option seller (option writer), you earn premiums from the options you sell, regardless of whether the option is exercised.

Let’s say you identify a fundamentally strong stock that you believe is slightly overpriced but would make a great addition to your portfolio if purchased at your calculated intrinsic value.

So you sell a put option with a strike price set at your calculated intrinsic value. The buyer now has the option to sell you those shares if the stock price falls to your strike price. If the stock falls to or below the strike price, you acquire the shares at your target price. If it doesn’t, the option expires and you can repeat the process, continuing to generate income.

Using put options strategically can effectively reduce the cost basis on investments you’re planning to acquire. For instance, if you receive $2 in premiums per share by selling puts on ABC Inc., and you eventually buy the shares when they dip below your strike price, that premium effectively lowers your cost by $2 per share. So, even if ABC Inc.’s market value fluctuates post-purchase, your breakeven point improves thanks to this reduction in cost.

Key considerations when selling put options

When selecting stocks for selling put options, a few key considerations can help you make informed choices.

  • First and foremost, focus on stocks you would be already comfortable owning should the option be exercised. Prioritise quality companies with solid fundamentals and a long history of growing earnings.
  • The volatility of the stock should be considered. Typically, higher volatility translates to higher premiums and increases the likelihood of the contract being executed. For example, a highly volatile stock like Tesla (TSLA) might offer attractive premiums due to its price swings but carries a higher risk of reaching the strike price than a more stable company like Coca-Cola (KO).
  • Keep in mind that put options in the U.S. are sold in contracts of 100 shares each. If the stock price falls below the strike price of the put contract you sold, you will be obligated to purchase 100 shares per contract. Therefore, ensure you have sufficient cash in your brokerage account to avoid potential margin calls.

How I successfully used put options

During the peak of the COVID-19 pandemic in March, I implemented a put option strategy with Carnival Corp, one of the world’s largest cruise companies. At that time, I decided to sell put options with a strike price of US$12.50, expiring in six months, earning me a premium of US$2.90 per share.

My rationale for choosing the US$12.50 strike price was grounded in the fact that the company’s tangible book value per share was US$25.36. This valuation indicated that Carnival Corp’s assets were significantly higher than the strike price, suggesting a considerable margin of safety even if I had to purchase the stock at the strike price of US$12.50. I believed it was highly unlikely for Carnival Corp to lose 50% of its tangible book value, even in the face of prolonged recovery periods and the severe impacts of the pandemic on the cruising industry.

I was also confident that the cruise sector, still a relatively underpenetrated market, would eventually rebound, reducing the company’s risk of going out of business completely. The stock price eventually fell slightly below my strike price, and the put contract was executed, enabling me to purchase the stock at my target price while also earning an additional premium of US$2.90 per share. By 2021, the Carnival Corp stock price had significantly recovered to US$30.

The fifth perspective

Understanding put options can significantly expand your investment toolkit. By selling puts, you can earn income while potentially reducing the cost basis of your investments. This strategy offers a way to wait patiently for stock prices to drop without incurring massive opportunity costs from idle funds. With careful stock selection and proper risk management, the rewards of using put options can be substantial. As you grow more familiar with put options, you’ll find they are an invaluable addition to your investing strategy.

Wang Choon Leo, CFA

Choon Leo is a growth-focused investor with an interest in innovative platform businesses that can connect users and fix market inefficiencies. He believes that companies with the most competitive business models will compound in value over the long term. Choon Leo is a CFA charterholder.

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