When the best investors speak, I listen. If you're like me, you know that at least as much can be learned from history's wealthiest entrepreneurs, too. So when the money studs of today and yesteryear are spouting the same knowledge, I take the branding iron from the fire and sear that knowledge straight into my brain. Consider this:
[Investors should demand] unvarying insistence upon the reasonableness of the price paid for each purchase. -- Benjamin Graham
Watch the costs and the profits will take care of themselves. -- Andrew Carnegie
As investors, we should be very picky about the price we pay for our stocks. But these days, while we're waiting patiently for better prices, we are earning close to nothing on the cash sitting in our brokerage accounts. To maintain the discipline of only paying a good price while at the same time boosting your returns from option income, consider writing put options to buy into a pricey stock.
Make patience pay you by writing puts
A put option represents the right to sell a stock at a certain price on or before a specific date. So writing puts means that you promise to buy a stock at an agreed-upon price (the strike price) in exchange for a bit of cash. Using written puts to establish ownership in solid businesses, while earning income on your dry powder, is a sensible way to invest using options.
Here's a quick example of how it works: Shares of Pop's Toaster Repair (Ticker: POPS) trade for $60, which equates to a P/E of 40. After having been burned by toast-related companies in the past, you're willing to pay only up to 30 times earnings, even for a company as well-run as Pop's. So to potentially purchase shares at $45, you decide to write a put option. Currently, put options that expire in six months and have the $45 strike you're looking for pay $2.50.
Because each put option represents 100 shares, your $2.50 payment of put option premium is actually $250 and the cash you need to set aside to purchase shares if exercised is $4,500. If POPS declines to $45 or below, you simply use the $4,500 you set aside to purchase 100 shares. If not, you get to keep the $250, and have effectively earned a dividend on your dry powder of 5.6% in just six months. Plus, you can consider writing another round of puts if you still want to try to buy shares at lower prices.
A quick glance highlights the two major risks of writing puts: (1) You may not get to buy the shares if the price doesn't fall, and (2) if shares plummet, the losses below the strike price – all the way to zero -- are yours. For this reason, it is vital that you are only writing puts on solid businesses and are willing to own their shares, even if the share price falls considerably.
7 stocks for your dry powder
Seven in particular struck me as having the potential to be great long term investments if we can nab shares for just a bit cheaper.
5-Year Revenue Growth Rate
Data from Capital IQ, a division of Standard & Poor’s.
If touchscreens are the future of computing and entertainment, then Synaptics has its finger on an exciting future. The company continues to innovate and sells its tactile products into some briskly growing markets: mobile devices, netbooks, and tablets. This market is projected to grow an average of 19% annually until 2014. As a bargain shopper (especially for high-tech investments), I'd be happy to own shares if they went on sale by 15% or so.
Instead of passively waiting for shares to drop from $30 down to our preferred entry price of $27, we could write a $27 put option expiring in March 2011 for $1.30 and get paid for waiting. If shares drop and the put is exercised, we’ll own shares at a net price of $25.70 (via the $27 strike price and the $1.30 in premium); that's more than 14% below current prices. If Synaptics fails to fall, we keep $130 in premium, which represents a 4.8% payment on the funds set aside (in only 100 days). Given the great long-term prospects for Synaptics, we could then consider writing another round of puts with the same goals.
The Foolish bottom line
Finding solid businesses selling for reasonable prices remains the key to success in investing. But for value-minded investors, getting paid for being patient by earning income on your dry powder can make waiting much more profitable.
To learn more about the profitable options strategies we've been using in real-money portfolios for years, simply enter your email address in the box below to receive information on Motley Fool Options, plus our free options guidebook.