Using Put Options: How to Grab Discounts and Instant Money Everyday

by Lee Lowell, Stock and Commodity Option Specialist
Wednesday, November 25, 2009: Issue #1145

Forget Black Friday. The stock market has 3,000 items on sale – and ready to give you cash back… instantly.

Over the past few weeks, I’ve discussed how you could have sold put options to go long on gold or silver through their respective ETFs – the SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV).

However, I’m going to show you how it works equally well on regular stock options, too. And with more than 3,000 stocks that have options available to trade, you’d better believe there are plenty of opportunities for you to grab the double benefit of being able to buy stocks at a discount to the current price and also get paid.

This is something I do all the time in my Instant Money Trader (IMT) service, using put options on quality Dow Industrial and S&P 500 companies. Here’s how it works…

Why You Should Sell, Not Buy Options

When it comes to buying options, here’s the phrase that doesn’t pay: time decay.

Most buyers tend to overlook this crucial factor when they buy options contracts. That’s because while an option is in existence, it will lose a bit of its value every single day, as it heads toward expiration.

Simply put, if the stock or commodity doesn’t make the desired move in the allotted time, the option value just melts away, giving the buyer almost no chance of making money.

The facts bear this out, too. The Chicago Mercantile Exchange reports that up to 80% of out-of-the-money options will remain that way at expiration and expire worthless.

So if buyers lose out, it stands to reason that sellers profit in their place. This is the overriding reason why we like to sell out-of-the-money options. The bottom line is that our chances of profiting are greater.

Not only that… if we’re obligated to buy shares of our chosen company at options expiration, we get to buy the stock at the price we selected – one we deem extremely attractive.

Here’s how it works in reality…

The Breakdown of a Put-Sell Trade

In March 2009, we initiated a put-sell trade in my IMT service on one of the largest companies in the world – General Electric (NYSE: GE).

At the time, GE was trading near $10 per share – a level it hadn’t seen since September 1995. We felt that potentially buying GE even lower would represent an outstanding long-term bullish trade if we got the opportunity. Specifically, we aimed to buy it at $7.50 per share.

• We sold the June 2009 $7.50 put option contract for $0.65 per contract.
• Since each option contract obligates us to buy 100 shares of stock, that’s $65. In our model portfolio, we sold 10 contracts – equivalent to 1,000 shares.
• At that point, we were obligated to buy 1,000 shares of GE at $7.50 per share if GE traded down to $7.50 by June 2009 option expiration.
• With the $0.65 per contract that the option buyer was paying, we collected a cool $650 ($0.65 multiplied by 10 contracts = $650).

So the trade was simple: We decided that we’d be happy buying GE for $7.50 per share, sold the corresponding put options at that strike price and collected “instant money.”

As long as you’re comfortable with your buy price ahead of time, you’re entering into a win-win scenario. You not only get to collect money upfront from the option buyer, but also potentially get to buy a stock at the price you want.

As you can see on the chart below, GE did dip below $7.50 (it actually traded down to $5.72), but popped back above $7.50 before expiration.

The deciding factor in whether you’ll be able to buy the stock at your price is if the stock actually closes below the strike price at which you sold the options on expiration day.

In our case, GE stayed above $7.50 by option expiration, so the option expired worthless. We would have kept the full $650 that we collected on day one of the transaction, but we opted to take the trade in a different direction…

Trade Not Working Out? No Problem… You Can Still Profit With Put Options

As with any transaction, you can always offset your position by bouncing to the opposite side. If you buy an option, you can offset it by selling it. And if you sell an option (as we do in IMT), you can offset the trade by buying the option back.

This is what we did with GE.

• When GE started to move back up towards $12 per share, we opted to buy the option back for $0.15 per contract and closed the trade.
• Remember, we sold the option for $0.65, so we locked in a $0.50 gain per contract.
• On one contract, that would be $50, but because we sold 10 contracts, it equated to a $500 gain.

There’s nothing wrong with closing out a trade before option expiration. In fact, you can close any option trade at any time you choose.

So, although we never got to buy GE at the price we wanted ($7.50 per share), we still got $500 for our trouble while the trade was active. This is the exact type of trade that we execute in IMT all the time. And with a few positions open each month, we can collect a tidy sum over the course of the year, giving your account value a nice boost.

Good trading,

Lee Lowell

Editor’s Note: Stay tuned for a special “pre-parade, pre-turkey” report on Lee Lowell’s Instant Money Trader service in your e-mail first thing tomorrow morning. But if you don’t want to wait until then, or will be waist-deep in Thanksgiving activities, you can take a look at it right now.