Selling Put Options to Acquire Shares
27/10/2017
In this top trade idea, we will discuss options and how to use them conservatively. We will use examples of how investors can use them to acquire shares in companies that they are looking to buy in a more
conservative way than buying the stock directly from the market.
Disclaimer: In this article we discuss exchange traded options as opposed to binary options.
Options can be confusing, if any members would like a further explanation of how the concept works then please let us know.
Introduction
At we like to compare options to what it would be like driving a Ferrari from Dunedin to Auckland. It is
possible to drive conservatively and have a safer and more comfortable ride than if you were driving a 1995 Toyota Corolla. Conversely it is also possible to drive a Ferrari at 200km and get to Auckland a lot faster but with a lot more risk.
Most investors do not have a real understanding of the risks they are taking when they trade options. Often people are driving Ferraris when they think they are in a Corolla.
This involves many investors taking onboard significantly more risk than they are intending too when they trade. This leaves options getting a bad name with investors and labelled as a risky investment.
While many options traders do drive their Ferraris recklessly, options can be used to
acquire shares more conservatively than what they can be purchased for off the
market.
Context
Before we begin it is important to clarify some context. Within the confines of this
article we are imagining a situation where:
• An investor has identified a stock that they are happy to purchase at least 100
shares in.
• The investor has identified a price at which they are happy to purchase these
100 shares.
• The stock in question has options available (this can massively limit the
investable universe).
Put Options
For the purposes of this article we are talking about put options. A put option gives
the owner (the buyer) of the option the right but not the obligation to sell an agreed
number of shares on an agreed date. A put option is a contract that is made with
counterparty that writes or sells the option. The buyer of the option pays the writer of
the option a premium to own the option.
Typically the owner of a put option will benefit if the price of the underlying instrument
decreases in value while the writer of the option will benefit if the price stays the same
or increases.
Put options are commonly used to hedge downside risk (insurance) with a stock or a
portfolio but also as leveraged directional bets on a stock.
Theoretical Example
This is how options are traditionally used. An investor owns 100 shares of XZY at $10
per share. To protect their downside risk they decide to buy a $9.50 put option. The
cost (premium) of this option is $0.50 per share or $50 (100 shares X $0.50). This
premium is paid to the writer of the option.
There are a couple of days that this can play out:
Scenario 1: The stock price drops to say $5 per share. The investor has the right to sell
his shares to the writer of the option for $9.50. As the investor purchased shares of
XYZ at $10 his downside is limited because of his ability to sell at $9.50.
Scenario 2: The stock price goes up, stays flat or deceases to an amount that is higher
than $9.50. In this situation the option is worthless. This is because the stock is trading
at higher than $9.50. Why would an investor want to exercise his right to sell the stock
at $9.50 if he can sell it to the market for more? In this instance the option expires
worthless, the writer of the option receives the premium and the trade ends.
How to use Put Options to Buy Shares:
Let’s imagine an investor that wanted to buy 100 shares of the Commonwealth Bank
of Australia (CBA.ASX) to hold long term. At the time of writing the last traded price of
CBA was $78.99 per share.
Let’s also imagine that this investor did not want to pay more than $76 per share. A
3.79% discount to its current trading price. This is the price that the investor feels is a
good price to get into the stock to buy and hold at.
The first choice for the investor would be to place a limit order at $76 per share and
leave it open. If CBA drops to $76 or below then the order is executed and the investor
buys 100 shares of CBA as he wanted to do.
The second choice would be for the investor to write or sell 1 put option at $75 per
share. This means that the investor is making the commitment to buy 100 shares of
CBA from the buyer of the option if the stock is trading at below $75 when the option
ends.
The $76 options expire in one month (November 23rd 2017) and the last traded price
was $0.26 per share. The buyer of the option pays our investor $26 (0.26×100) for the
option. This premium will vary from stock to stock depending on the stocks price, the
time of the option and volatility.
Lets compare the two choices:
Choice 1
Choice 2
Places an open limit order to buy 100 Sells 1 $76 put option of CBA expiring
shares of CBA at $75 per share
23/11.
If CBA does not drop below $76 per share between now and the 23rd of November:
Choice 1
Choice 2
Is sitting with the option $76 limit order Has also $7600 sitting in an account
nothing happens and $7600 sitting in an unused but has been paid $26, the cost
account unused
of the premium while waiting. On expiry
this investor may decide to sell another
option
Lets say that CBA drops in price and is trading at $75 per share:
Choice 1
Choice 2
The limit order of $76 per share is The put options for this investor are
executed and the investor purchases 100 executed and the investor is “assigned”
shares. On paper the investor is down $1 or has to buy 100 shares of CBA at $76
per share or $100.
per share. The stock is trading at $75 per share but instead of being down $100
the investor is only down $74 because they have received the $26 premium.
Remember in this example that both investors wanted to buy CBA for $76 per share
and both investors have done that. If the stock had never gone below $75 per share
the investor could keep selling put options each month and make money while placing
a limit order leaves money in the account unused.
Lets say CBA crashes significantly down in price. In this case both investors were going
to buy CBA anyway only when selling a put you are paid money upfront so the losses
are less.
When an investor is looking to buy a stock at a set price that is below the current price
a put option may be worth considering. In this instance because the investor receives
the premium it is more conservative than placing a limit order.
Warren Buffet
The “Oracle of Omaha” famously sold options in this way to purchase shares of Coca Cola (KO.NYSE). In 1993 Buffett sold 50,000 contracts of put options on KO for
$1.50 per share. Because Buffett was a happy buyer of KO he was happy to pay a lower price if it dropped. In this instance Buffett received premiums of $7.5 million for the options in KO.
Risk & Downside
• The key thing to remember is that an investor should only sell put options in
this manner if they want to own the stock. Otherwise you may end up owning
a stock that you never wanted.
• It may not be the best risk reward play if you thought a stock had unlimited
upside. The most profit you can get is the premium received. If CBA ran from
$78.99 per share to $100.00 the investor would miss out on the upside.
• As they are typically written over 100 shares it options can be inflexible with
high share prices. For example, most individual investors do not have the
capital to purchase 100 shares of Amazon at over $1000 per share
• Options are not readily available on New Zealand stocks. They are however
available on most larger Australian companies and virtually all US stocks.
Conclusion
Options can be dangerous and should be considered high risk investment vehicles.
However savvy investors can use them conservatively to purchase stock that they are
interested in.