Trying to time buy and sell orders can be a stressful task for any long-term investor. When you're not in and out of the market all day long, how can you possibly know where a stock is going to move in the short term? And when you sell just before the stock pops, you're left kicking yourself.
But stock options can ease some of that stress by giving a discount to buyers and a premium to sellers. If you know a little bit about how volatility and time affect option prices, as we discussed yesterday, you're halfway there. Now it's time to get to the meat of it: what strategies to use to make your trades more efficient.
Using options to buy at a discount
Say you have a stock picked out, you've done your due diligence, and you're ready to pull the trigger -- but the price is a little higher than you'd like to pay. Why not use options to buy that stock and get a discount in the process? To do this, you sell a put, which will potentially result in your owning the shares at the price you want while getting paid a premium for the put you sell.
Let's look at a recent put option sale I made as an example. In January, I identified Melco Crown
At the time, the stock was trading for $7.37, but if the put buyer eventually exercised the options, my net purchase price would be $6.65 -- the $7 strike price of the option minus the $0.35 in premium I got for selling the put. Not a bad discount of almost 10% to the share price at the time. If my options weren't exercised, I'd pocket the $35 profit.
|Melco trades above $7 at expiration||Melco trades below $7 at expiration|
|At expiration||$35 profit per contract||Pay $700 per contract for 100 shares; net cost $665|
As it happened, Melco traded at $6.84 at options expiration, and my contracts were exercised. But I got a better net price than what I could have paid for the stock at the time -- and I didn't take the loss I would have if I'd purchased at $7.37.
I like to use this strategy in volatile stocks where catching the bottom is nearly impossible, and I almost always watch the stock fall just days after buying in. Gaming stocks are perfect for this strategy and so are solar stocks, another sector I follow closely. The stocks can be very volatile, but by selling out-of-the-money put options -- put options with a strike below the current stock price -- you can get a significant discount from the current stock price if the options are exercised. I've chosen four solar stocks from My Watchlist that have low P/E ratios, high betas and a nice discount if my put options were exercised.
Recent Stock Price
May Put Option Price
"Discount" If Exercised
||$17.47||$0.95 ($17 strike)||8.1%|
||$6.57||$0.25 ($6 strike)||12.5%|
Yingli Green Energy
||$12.37||$0.55 ($12 strike)||7.4%|
||$28.76||$1.65 ($28 strike)||8.4%|
If exercised, each stock option gives us a nice discount from the current stock price. And if it isn't exercised, we get to pocket the cash.
Using options to sell at a premium
Options can also be used in a similar way when you're looking to sell stock. In this case you sell call options to "cover" your stock position by selling one call option for every 100 shares you own.
After watching two of Dreamworks Animation's
Foolish bottom line
Knowing how to use options to your advantage can be good for any investor's portfolio, especially if you invest in highly volatile stocks that carry high option prices. But you only let options work for you when you sell them and collect the premium. The downside is that options are sold in 100 share contracts, so for small portfolios or high price stocks, they're not always workable. But they're a great tool for retail investors to know about.
Fool contributor Travis Hoium owns shares of Melco Crown and Dreamworks Animation. The position in Dreamworks is covered with call options. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.
DreamWorks Animation is a Motley Fool Stock Advisor recommendation. Melco Crown Entertainment is a Motley Fool Global Gains selection. 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.