Let's face it, we're ALL looking for discounts. I don't care if you're rich, poor, hurt by the economy, or not...everyone loves a discount. And since this is a site that focuses on trading/investing, what better then to learn about how to get a discount for a stock! To help us learn the art of the discount, I've asked Phil Davis from PhilStockWorld.com to come and enlighten us. Enjoy the article and tell us where you've found great discounts!
If this market hasn’t convinced you that buy and hold is a gamble - I don’t know what will.
Holding any stock for more than a day has been a sure recipe for heartache (sometimes just an hour will do it) but it’s possible to regularly get much better prices than the ones paid by the average retail investor using a very basic option strategy. This strategy, which we call a "buy/write" – buying the stock and writing options against it - is one of our most effective tools for dealing with a choppy market.
There are, of course, many, many stocks trading near multi-year lows and it’s still important to select ones that have strong underlying fundamentals that we actually don’t mind holding long-term but, as long as you’re willing to own 200 shares of a stock, this system can reliably give you a 10-20% discount off the current market price. It’s simple, easy to follow and is ideal for trading in a volatile market.
Of course when we buy any stock or long-term option position, we should be scaling in. In other words - we don’t assume our timing is perfect and we enter a position in stages. Selling puts and calls against a stock entry is a way of automatically following the scaling system without having to monitor your position that closely.
Let’s say, for our first example, we want to buy BAC at $8.26. If our goal is to buy 200 shares we buy instead 100 shares and also sell the June $8 puts for $1.65. Additionally, we sell the June $8 calls for $1.77. The two sold contracts reduce our net basis to just $4.84 and we have taken on two obligations. The call we sold obligates us to sell our stock for $8 on June 19th IF the price of BAC closes above $8 on June 19th. We have sold someone an OPTION TO BUY our stock for $8 on that date for $1.77, which we keep, whether they exercise the option or not. Our second obligation is on the put we sold. By accepting money for the put, we have agreed that, in exchange for $1.65, the put holder can "put" the stock to us (force us to buy it from them) for $8. They can do this at any time prior to Dec 20th, no matter what the price of the stock but, of course, if the stock stays over $8, there would be no point for them to put it to us at a discount.
So, if BAC finishes the expiration period above $8, we will have our 100 shares called away at $8 and our put holder will expire worthless. The profit on that trade would be $3.16 per share against our net outlay of $4.84, a 65% profit in 8 weeks. On the other hand, should the stock be put to us below $8, then our caller would be expiring worthless but we will be forced to pay $8 for 100 additional shares of BAC, regardless of what price it’s currently trading at. With our original 100 shares at net $4.84 and 100 more at $8, our new net basis would be $6.42 - which is 22.3% lower than the current price.
This is a simple example over a short period. The key is to pick stocks that are:
1. Trading near lows
2. Fairly volatile
3. NOT likely to go bankrupt – Undervalued
4. Either pay dividends or have good growth
5. Have a clear path of continuing contracts to write
6. You don’t mind owning long-term
In short, if you think BAC is near a bottom at $8.26- why not commit to buying it for $6.42 instead? Also, to take a more advanced view, the trade doesn’t end on June 19th. You have a $6.42 basis in Bank of America, which may or may not continue to pay a .16 annual dividend. If they do, that’s another 2.5% return on your money. Additionally, you can continue to sell calls against the stock. Let’s say BAC falls all the way to $5 and you are stuck in it at $6.42. You can still sell $7.50 calls for .10 or more. While this is not absolute, I can see that the May $12.50 calls, which are $4.24 out of the money are selling for .12 so it’s not a big stretch to assume we can pick up a dime for the $7.50s if BAC dips to $5.
With a basis of $6.42, we don’t mind being called away at $7.50 (up 17%) and, if we sell just .10 12 times during the year, that’s an ADDITIONAL $1.20 return per share or a 18.7% return on our $6.42 investment while we wait (profitably) for BAC to come back in value.
Also, these plays are not static at all! We just did a similar play on LVS Tuesday afternoon, buying the stock for $5 and selling the May $5 calls for .80 and the May $5 puts .85. That made his net basis $3.55 (a 33% discount off the price at the time!). Had the stock gone down, we would have had an average entry of $4.28, 14.5% lower than the $5 entry. LVS shot up to $5.63 today, making the trade look very safe and the puts we sold fell to .57 while the calls climbed to $1.20. That gives us a current net of $3.86, alreay .31 higher than yesterday (up 8.7%). We are not forced to wait for May 15th, we can close out the trade now for a nice one-day profit by simply buying back the puts and calls and selling the stock or we can ROLL the puts and calls. That just means buying out the current set for $1.77 and then selling a different set of puts and calls at a more advantageous position.
If we were gung-ho bullish that LVS was heading higher, we could trade our $1.77 May $5 puts and calls for the June $5 puts at $1 and the June $6 calls at $1.60. That actually puts another .83 in our pocket (the net credit from the roll) and LOWERS our basis to $2.72 AND RAISES the amount at which we’d be called away from $5 to $6. It’s a win/win/win for us - it’s like a magic trick! If LVS does finish June 19th over $6, we are given $6 for our stock, the puts expire worthless (we keep the money) and the trade closes with a $3.28 profit (up 120% in 8 weeks). If the stock is put to us below $5, our net entry is $3.86 the average of the $5 we pay for more shares and the $2.72 we paid for the first round or $3.88, 22.5% below our $5 entry!
At this point you may be saying to yourself: "If I can learn to buy all my stocks for 22.5% discounts, I can probably improve my trading performance." That’s exactly what hedge funds do and there’s no reason you can’t learn to do it as well. The great thing is - there is always an option.
What if the stock goes down? - you may wonder. As we mentioned, if LVS falls to $3 on option expiration day, you are still obligated to buy another round at $5. Your average entry would be $3.86. You can do it all over again and give yourself another 20% discount, dropping your basis to $3.20 or lower. Of course you may end up with 400 shares at $3.20 but, since you started out willing to buy 200 shares at $5 ($1,000) and you ended up with 400 shares at $3.20 ($1,280) with the stock at $3 ($1,200) you are down just $80 (7%), not bad for a stock that fell 40% since you first bought it!
In this scary and volatile market, using options is one of the best ways for you to capitalize on the volatility while hedging the risk on your upside plays and positioning yourself for a (we hope!) recovery. If the market does end up flat-lining however, you will be positioned in stocks at good prices that can generate a very reasonable monthly income – keeping you flexible in a very challenging market!
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