By: Michael Tibbits, Instructional Designer
The recent drops in the stock market resulting from the Coronavirus have created buying opportunities for long term investors. If you are considering purchasing stocks, read on to see how you can use put options to your advantage.
Not familiar with put options?
Put options are contracts which give the holder the right to sell 100 shares of stock to someone else at a specific price, called the strike price, by or before a certain date, which is called the expiration date. Investors worried about stocks falling past a certain price will buy puts for those stocks to insure them against further losses.
For this protection, investors pay put sellers a premium, so in case the stock drops, the profit they make on the option offsets some of the losses on the stocks.
So, how can you benefit from this?
If you sell a put option, you collect a premium to buy 100 shares from someone else if the stock falls below the strike price.
Let’s use Walmart as an example:
Walmart (WMT) is currently trading at $115 per share. Let’s say you want to buy 100 shares if Walmart drops to $114 per share. That would cost $11,400. Simple math, right?
Now, let’s look at the put options for Walmart.
The 114 strike puts expiring April 17 are trading between $335-$345.
- If you sell the 114 strike put for $340 and hold it until it expires, you keep the $340.
What could happen?
From here there are two things that can happen:
Scenario 1: Walmart closes at or above $114 per share on April 17, 2020.
- There is a high probability that you will not be assigned to buy 100 shares of Walmart and you will keep the $340 credit.
Scenario 2: Walmart closes below $114 per share on April 17, 2020
- You will be assigned to buy 100 shares of Walmart at $114 and you will keep the $340 credit. The credit kept brings the cost for Walmart shares to $110.60 per share. Below is the math.
- $11,400 – $340 = $11,060 / 100 shares = $110.60 per share.
Now, of course this doesn’t mean Walmart can’t keep dropping in price, but if you were committed to purchasing 100 shares of Walmart stock at $114 per share anyway, then why not collect some credit for selling the naked put?
Have questions or opinions about this strategy? Tweet your questions at us (@youcantrade)!
Disclaimer: The author is not a financial advisor and the following should not be taken as financial advice. This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.