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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6 thoughts on “How To Buy A Stock For A 15-20% Discount”
Synthetics/Roger - That's a good idea, I will consider that for a later post. Ideally though, the idea of these plays is to establish ownership at a low price, it's something stock traders should be doing. In fact, if you are buying a stock and absolutely want to own it for a full year (perhaps for tax reasons) there is no reason at all not to do this.
ROI/Ray - Yes there are margin requirements but if you buy MGM for $5 and sell $2 worth of puts and calls then you have purchased 100 share for $500 less $200 back is net $300. You may have a $250 margin requirement on the naked puts but that does not change the fact that, if the next 100 shares are put to you at $5, your average entry is still $4 on 200 shares. Even so, I will ammend the post to mention margin requirements as I'm sure some people don't realize they will have them but note the plan is to scale into a position so, if you have the cash to execute the put side, the margin would not be an issue.
Volatility/Crash - Note the checklist. This is NOT a day trading technique. The vast majority of people in the markets buy stock for the long term and this is simply a way to buy them cheaper. I forces the idea of scaling into a position over time, something not enough people do and this forces a good discipline on entering positions.
If you look at MGM right now, it's at $6.08 and you can buy 200 shares and sell the June $6 calls for $1.45 so you are in for net $4.63 with a max gain of $6. If MGM closes at $5, you will be up .37 on 200 shares.
If however, you buy 100 shares of MGM at $6.08 and sell the June $6 calls for $1.45 and the June $5 puts for $1.35, you are in for 100 at net $3.28. You may have a $500 margin requirement on the put you sold but, either way, if MGM finishes at $6 you make $2.72 vs. 2x 1.37 in the other situation but, if MGM is put to you at $5, your average entry is $4.14 and you are up .86 vs .37 which is a pretty significant difference (more than 5% a month). If saving 60% a year is not worth the hassle then I really want to learn your system!
This can be a good method for purchasing stock in companies that you know aren't going out of business or for companies that do not tend to rise or fall very much, but not good for volitile stocks. Mostly because the stock price can drop far below the strike price causing an earlier excercise that may leave you with a bigger loss. This type of trading should also not be done without a very good understanding of technical charts.
As a last point, it should be noted that unless you have level 3 or 4 options trading permission the broker will deduct the strike amount from your account anyway to cover the option, so you still would have the money tied up in the stock. If you have level 4 options trading you have to cover the short option with maintenance margin until it expires. To date I have not found the hassle worth the benefit.
I am new to options trading. I am looking for a brokerage. It seems that most want large sums for the level 3 or 4 platforms.
These platforms seem to be beyond the reach of many. This may be the hassle refered to in the above post. I have noticed that many of the "profits" on trades seem to ignore the cost of commissions. In buying and selling stocks, I have seen most of alleged profits consumed by commissions. Which companies are best in this regard for those starting out, not dealing in high volume? Thanks, Liz
How to trade options in this choppy market
The calculation for return on investment is incorrect. For a long position of 100 shares of a stock, it is possible to sell 1 call contract without additonnal investment. However, in order to sell a Put contract ( in addition to the call contract), it is necessary to invest more money, since this is a naked put sell, there is additional margin requirements. The additional investement could be as high as 20% of the cost of the stock shares. Furthermore. in order to sell naaked option contracts, it is necessary to get a higher level of trading approval from the trader's brokerage house.
Very interesting article. I intend to use the information. It would be interesting if you would analyze a similar situation using synthetic stock positions: i.e. buy call, sell put, close to stock price, same number of contracts, same strike price, same expiration. I understand that in theory the gain or loss would be the same as buying the stock. Should we use your approach above in addition, it gets too complicated for me to figure out. Thanks for considering this. BobR.
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