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How Value Investors Use Put Options to Increase Their Returns
For many people, options are seen as risky instruments best left to the experts. And it is true – if you don’t understand options (or any other financial instrument for that matter), you best stay away from them!
But if you’re familiar and understand how a particular instrument works, you can use them in specific situations with little risk to boost your investment returns in a short period of time.
Let me use this analogy: Driving a car is risky if you don’t know how to drive; you can end up in a serious accident. But if you do know how to drive a car, your risk goes down substantially and it can help you reach your destination much faster.
You may have heard of the term ‘option trader’ many times before. An option trader uses options to trade the markets for a quick profit. There are many successful options traders out there and you need to have a good understanding of options and its strategies to be really good at options trading.
But that’s beyond the scope of this article, instead we will discuss how ‘old, boring’ value investors can use put options as well to increase their investment returns.
There are basically two kinds of options: calls and puts. We will just cover put options here.
If you buy a put option, it gives you the option to sell a stock at a certain price (strike price) before the option expires. In doing so, the buyer (option holder) pays a cash premium to the seller (option writer) for the option.
For example, you buy a put option that gives you the option to sell XYZ stock at $50 before the option expires. So if you own XYZ stock and the market price falls to $45, your option allows you to sell the stock at $50 giving you a better deal. Investors use put options from time to time to hedge against falling prices.
But we’re not interested in buying put options here, we want to sell them.
So on the other side of the coin, if you sell a put option, you are obligated to buy the stock at the strike price if the option holder chooses to exercise his option.
For example, you sell a put option that gives the buyer the option to sell XYZ stock at $50. In return, you receive a cash premium for selling the option. If XYZ stock falls to $45 and the option holder exercises his option, you are now obligated to buy the stock at the agreed price of $50.
You might be asking: So why do people sell put options in the first place? It seems like a huge risk!
The fact is, most options expire worthless and option sellers can collect a decent amount of cash premiums selling options (provided they understand their risk and exposure when doing so).
Put Option Strategy for Value Investors
So how does selling put options work as a strategy for value investors?
As a value investor, you wait to purchase stocks until they reach cheap, undervalued prices. So why not get someone to pay you to buy stock at low prices in the meantime?
Here’s how this works.
Let’s say, as a value investor, you’re waiting to buy ABC stock at $80 a share. It is now trading at $95. So in the meantime, you decide to sell put options with a strike price of $80. You collect a nice cash premium for it. So now two scenarios can happen:
ABC stock falls to $80 (or below). The option holder decides to exercise his option and you’re now obligated to buy ABC stock at $80. Congratulations! You now own ABC stock at the target price you wanted in the first place.
ABC’s stock price continues to go up or remain flat. The option holder will not exercise his option and his option expires worthless. You still don’t own ABC stock because it is overpriced and you collected a nice cash premium for ‘doing nothing’. Starting to see my drift?
You can now continue to sell put options and collect cash premiums repeatedly until one day ABC stock eventually hits your target price and the option is exercised. In that time period, you boosted your overall returns by collecting cash premiums many times before you finally purchased your value stock.
The point is – if you’re going to wait to purchase a stock cheap, why not get someone to pay you while you’re waiting? As you can see, selling put options can be a very useful strategy if you’re a hard-core value investor.
Even Warren Buffett Does This
Even though the beacon of value investing, Warren Buffett, has publicly revealed his concerns about financial derivatives (e.g. options, futures, etc.), he has also sold put options as a strategy in the past to boost overall returns.
In 1993, Buffett wanted to purchase five million shares of Coca-Cola at $35 a share. It was trading at $39 then. Buffett sold 50,000 contracts (5 million shares) of Coca-Cola put options with at strike price of $35 and collected $7.5 million in cash premiums upfront. If Coca-Cola stayed above $35, he still kept his $7.5 million in premiums. If Coca-Cola fell to $35, Buffett would buy the stock at the price he wanted anyway. It was a win-win deal for him.
Buffett did the same thing again for his investment in the railway company, Burlington Northern Santa Fe. Buffett sold nearly 5.5 million put options for BNI in 2008.
Important Considerations You Must Observe
As you can see, selling put options is a great way to generate cash income and boost your investment returns. But before you employ this strategy, there are three important considerations you must observe:
- You must have the cash to purchase the stock. If the stock falls to the strike price (or below) and the option is exercised, you must have the cash ready to buy the stock. If you sell more put options than you can cover, that is extremely risky because if the options are exercised you are now obligated to buy shares beyond what you can afford.
- You must be satisfied with the strike price. Sometimes, the stock’s market price might fall below your option strike price. But regardless, even if the stock falls below, you must remember that you’re already purchasing the stock at the initial target price that you’re already happy with.
- The company is fundamentally strong and secure. The stock you’re writing the put option for shouldn’t drop drastically in price for any foreseeable reason. If a stock crashes, you’re now stuck with buying a stock at a huge premium when the option is exercised. This is where your fundamental analysis comes in and you’re sure that you’re picking a stock that’s safe, solid, and reliable.
This article has shown you how investors can used advanced strategies to increase returns with hardly any additional risk. Now if you want to use put options as part of your investment strategy, it is critical you understand options fully before you jump into them.
Go learn and get familiar with how options work, option chains, strike prices, expiration dates, implied volatility, and the Greeks. Like my analogy earlier, make sure you know how to drive a car before you head down the freeway!
Options involve risks and are not suitable for everyone.
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This is not a recommendation to purchase or sell any of the securities mentioned on this site. The information contained herein are the opinions and ideas of the authors and is strictly for educational purposes only. This information should not be construed as and does not constitute financial, investment or any form of advice. Any investment involves substantial risks, including complete loss of capital. Every investor has different strategies, risk tolerances and time frames. You are advised to perform your own independent research or to contact a licensed professional before making any investment decisions. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth herein. Fifth Person Pte. Ltd., its related and affiliate companies and/or their employees shall in no event be held liable to any party for any direct, indirect, punitive, special, incidental, or consequential damages arising directly or indirectly from the use of any of this material.
Adam Wong is the chief editor of The Fifth Person and was featured on 938LIVE as a guest expert on MoneyWise. He is also the author of the national bestseller Lucky Bastard! which made the Sunday Times Top 10 Bestseller's List in 2009 and Value Investing Made Easy, which made the Kinokuniya Business Bestseller's List in 2013. An avid investor himself, Adam shares his personal thoughts and opinions as he journals his investing journey online. If you're interested to learn more about stock investing, you can join The Fifth Person Newsletter and receive free weekly insights on how you can generate higher returns and dividend income from the stock market.