Tackle the sticker shock of a lofty stock market with an options play. Consider lowering your cost basis by selling puts.
High-priced stocks are more common now that stock splits have lost the popularity they boasted a few years ago.
Examples are rampant among some of the most widely tracked companies. Warren Buffett’s Berkshire Hathaway (BRK.A) notoriously trades over $200,000 a share. Google (GOOG, GOOGL), Netflix (NFLX), and Priceline (PCLN) all trade over $500 per share. Until last year, Apple (AAPL) was a high-dollar stock, too, before it split 7-for-1.
While a high price doesn’t necessarily mean a high valuation, it can still cause stock market sticker shock. In fact, traders often suffer from sticker shock every time a stock rallies too fast past their targeted entry point.
For skilled traders who are seasoned in options, a strategy designed to sell puts as a way to buy stock at the strike price, but with a lower cost basis, may be worth a look. That's because credit received from selling options can reduce the cost basis of stock that is purchased through assignment.
Selling a put contract means you’re obligated to buy shares of the stock at a specific strike price before a certain day. You sell a put in exchange for a premium.
Just as an example, during one late-May trading day for an Internet company, if you were a trader with buying on your mind, you could’ve purchased shares for $426.85 each. Or, you might instead have sold a 420 put (worth 100 shares of the underlying) for about $625. You would be taking a premium, the $625, to assume the risk. And by doing this, you would have been ahead at least in the short term with the $625, minus commissions and fees.
Now, remember, if the stock pulled back to $420 per share or below, you would likely be assigned on the put and be required to actually buy 100 shares at the strike price. Let’s say the stock price closed at $418 at expiration. You would be required to buy 100 shares for a total of $42,000. This means you got to purchase the shares at a price that is lower than at the time you sold the put, plus you lowered your cost basis by $625 with the premium that you received for selling the option.
If the stock didn’t pull back, you would pocket the premium but you wouldn’t get the stock. But if you felt the stock was overpriced, then hey, you were probably okay with that.
Selling puts gives you a premium that can lower your cost basis, can allow you to buy stock at a lower price than what it was trading at when you sold the put, and gives you the potential for profit whether you’re assigned the stock or not. However, it’s important to realize this is risky business, because the stock can still drop further. This means you must be comfortable with owning the stock at the strike price and be willing and able to shell out the cash to pay for it should you get assigned.
When you sell the put, you obligate yourself to buy the shares. If the stock keeps falling, you still must buy it at the contracted price. Of course, you would’ve had this same risk if you purchased the stock outright. With the put sale, you've offset the potential loss with the premium received.
You also have what’s called an opportunity risk. If the stock were to rise higher than the value of the premium received for the sold put option, then you might have been better off buying the stock outright. Yep, that’s another risk.
Selling puts this way is designed to work best during times when stocks go up slowly, drift sideways, or move down slowly.
Figure 1 compares the performance of the CBOE S&P 500 PutWrite Index—an index that tracks the performance of selling puts on the S&P 500—to the S&P 500 index itself. Over a long time frame of steady, slow growth for the S&P 500, the put-selling strategy tended to outperform, but that changed somewhat when the SPX’s gains accelerated. As you can see, selling puts historically performed better with stocks that are slow growers versus fast-moving stocks, at least as a long-term strategy.
FIGURE 1: MARKET CONDITIONS MATTER. The window on the left shows that the selling put index (gray line) outperformed the S&P 500 (SPX) (pink line) over the last eight years. However, the window on the right shows that the relative fast growth of the SPX outperformed the put index when the time frame is narrowed to three years. Data source: CBOE. For illustrative purposes only. Past performance does not guarantee future results.
Finally, remember that your likelihood of buying the stock will depend on the put you sell. The closer your put is to the price of the stock, the higher the premium will be, and the higher the likelihood that you’ll end up owning the shares. However, you may not get the discount you were hoping for, which is why you need to weigh the premium you want against the discount you want.
Also consider how long you want to be in the trade. Selling puts means that theta, or time decay, is working in your favor. Therefore, choosing contracts that are less than 50 days from expiration will give you faster time decay. Remember, if this one expires, you get to keep the premium, less the transaction costs, and you can always sell another put. That is, if you still like the stock.
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