This article was updated on Feb. 16, 2016.
Apple (NASDAQ:AAPL) stock is down by nearly 25% from its highs of the last year. That's quite a big movement coming from the biggest listed corporation on the planet, but it doesn't mean Apple can't continue declining in the short term. For investors who would prefer to buy Apple stock at lower price levels as opposed to going all in at these prices, selling put options on the stock could be a smart strategy to consider.
How put selling works
A put is basically a derivative contract that provides the buyer the right, not the obligation, to sell a particular security for a specified price over a determined period of time. For example, put contracts on Apple stock with an expiration date on Oct 21, 2016, and a strike price of $80 per share allow the buyer to sell 100 shares of Apple stock at $80 until that date. The put buyer needs to pay a price to purchase this option contract, currently around $400.
When you sell a put contract, you collect the option price, and you're committing yourself to buying the stock if the contract is executed. If Apple stock is trading below $80 per share at the expiration date, then the contract will be executed, so you will need to buy 100 shares at $80.
Would you be willing to invest $8,000 in Apple stock at a 17% discount versus current market prices? If so, you won't have many regrets if the put is executed. After all, you're buying a rock-solid company for a convenient price, and this can be a great strategy for big investment returns over the long term.
Besides, you also make the money from selling the puts. If the contract price is $400, you can deduct that from the investment cost. That means you're effectively paying $76 per share for Apple stock.
On the other hand, if Apple stock is above the strike price at the expiration date, the puts won't be executed. Nobody will want to sell the stock at $80 to you when it can be sold for a higher price in the open market, so the puts become worthless at expiration.
In that case, the put contract has a price of zero. Since you sold the contract for $400, you pocket that money as pure profit, and you have no obligations whatsoever after the expiration date.
In a nutshell, if Apple stock is above the strike price at expiration, you get to keep the put price as profit. If the stock is selling for less than the strike price, the puts will be executed, and you will need to fulfill your obligation and buy 100 shares of Apple at the strike price.
Why Apple is a strong candidate for this strategy
When you're looking to buy a stock on a pullback, selling puts has one key advantage over simply waiting for a better entry price. With put selling, you make a profit if the stock never comes down, so you're being rewarded for your patience and still making money if the stock price never reaches your target entry price.
On the other hand, since you're making a commitment to buy in the future at a specified price, it's of the utmost importance to know the company deeply and be absolutely convinced of the merits of such an investment.
Apple is one of the most prestigious businesses around. The company is ranked as the most admired company in Fortune, and Forbes considers Apple the most valuable brand in the world. These accolades have clear implications when it comes to competitive strengths, customer loyalty, and reputation among the investing community.
The balance sheet is rock solid, Apple is sitting on nearly $216 billion in cash and liquid investments, and the business brings in tons of money on a recurrent basis. Apple generated $27.5 billion in operating cash flow and almost $24 billion in free cash flow during the quarter ended in December of 2015. Even if there is some kind of slowdown in growth down the road, the financial soundness is downright unquestionable.
Put selling is a great strategy to apply on trusted and dependable companies that you would be happy to buy at lower prices, and Apple is an exemplary candidate from that point of view.
Andrés Cardenal owns shares of Apple. The Motley Fool owns shares of and recommends Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.