The following article was rejected by the Seeking Alpha editors because their focus is on long term investing and not trading. Apparently they don't understand that the use of selling options can be a conservative strategy. And the only reason I submitted the article was to help investors learn how to buy a stock for a price below the current trading level.
Many investors consider the use of options as a high risk strategy. But depending on how options are used, the use of options can fit into the portfolio of even the most conservative investors.
Every option transaction has two sides, the buyer and the seller. With both calls and puts, the buyer of an option is generally taking a bigger risk than the seller of the option because the clock starts ticking the moment the option is purchased. For a call buyer, the stock must rise within the option period in order to make a profit. For a put buyer, the stock must fall within the option period in order to make a profit. If the stock price goes in the wrong direction, the value of the option declines. The value of the option will also decline if the stock stays flat because the option expiration dates gets closer and closer. Option buyers are faced with the possibility of losing 100% of their investment.
On the other side of the transaction, the option seller has time on his side. Whatever the buyer loses is a gain for the option seller. Because options have no intrinsic value, at any given time during the life of the option, the sum of the buyer's and seller's gain and loss is zero. It's similar to the strategy encountered in a gambling casino; the option buyer is the gambler and the option seller is the casino. But in the case of the options game, an individual investor is not limited to buying options; he can also choose to be the seller!
Thus selling options can be considered a conservative strategy if done properly. Be aware that not all option selling strategies are conservative. The strategy outlined below is the most conservative of option selling strategies.
Suppose there is a stock which I want to purchase, but rather than buy it at the current price, I would like to buy it at a price below its current trading level. I have enough cash in my account to make the purchase. Instead of buying the stock outright, I can sell one or more put contracts at a price below the current trading price. One contract represents the right to purchase 100 shares of the stock. I can choose the purchase price (strike price) and the time period (expiration date) for the purchase. If the price of the stock drops below the strike price on or before the expiration date, the shares of stock will be "put" to me and I will have acquired the stock at a lower price. This strategy is referred to as selling cash secured puts.
The following conditions will make this a conservative strategy:
- The seller of the put wants to own the stock.
- The seller of the put has the cash needed to own the stock.
- The strike price chose is below the current trading level of the stock.
- A relatively close expiration date is chosen.
The biggest disadvantage of using this strategy is that the stock may continue to rise and the option will not be exercised. This is an opportunity cost because the gains of actually owning the stock may turn out to be greater than the gains from selling the option. But the disciplined investor will just continue to monitor the stock and look for the next opportunity to either buy the stock or repeat the put selling process. If the stock continues to decline, the transaction can be closed, possibly at a loss. But unless other factors have caused you to no longer want to own the stock, just allow the option to be exercised.
I only use this strategy when considering the purchase of high quality stocks with low levels of volatility. The stock must also have sufficient open interest to provide liquidity. And the strategy is particularly suited for a sideways moving market, without a strong upward or downward trend.
Not all stocks are good candidates for selling cash secured puts. The premium received in the transaction must meet your perception of the risk involved with the trade. I have had success selling cash secured puts with stocks such as McDonald's Corp. (NYSE:MCD), Wal-Mart Stores, Inc. (NYSE:WMT), Target Corp. (NYSE:TGT), and The Coca-Cola Co. (NYSE:KO) and others as well. The important part is to engage in this strategy with stocks that you are willing to own. The strategy fails to be a conservative strategy if you only evaluate the strategy based on its anticipated return.
Selling cash secured puts can be a conservative strategy if it is used as a means of buying high quality, dividend paying stocks at a price lower than the current trading level. It will put money in your account during the time period you are waiting for the option to be exercised. And you will keep most or all of the money in a sideways or upward market. But I would only recommend employing the strategy if the stock is one that you are willing to own.
Disclosure: The author is long MCD, WMT, TGT, KO.