If an investors is looking for a quick entry into a highly liquid stock he may choose to use a market order rather than a limit order.
However, if he wants to guarantee the price he pays for his shares he will always place a limit order, which will typically be at or below the current quote, unless he is a breakout trader, then his buy limit order may actually be above the current stock price.
Another stock entry technique—which is arguably better than a limit or a market order, especially when trying to buy at or below the current market quote—is to first sell a put option on the stock you wish to acquire and hope for assignment.
Doing so not only allows you to guarantee the price you pay for your shares, which can be at, below, or above the current quote, but also allows you to generate additional income which can lower your cost basis even further.
The risk is if on option expiration the stock isn’t trading at or below the strike price of the put option you sold, you never end up buying shares. If the stock then moves higher, you miss out.
In April 1993, Warren Buffett sold 50,000 contracts (the equivalent of 5 million shares) of out-of-the-money Coca-Cola put options for $1.5 per share and generated $7.5 million in up front cash.
If Coca-Cola stayed above $35 per share on expiration, he got to keep the $7.5 million in cash but would not be assigned the 5 million shares.
If Coca-Cola dropped below $35, through assignment he would effectively purchase the stock at $33.50 ($35-$1.5 option premium), which was a great price anyway. It was a win-win situation.
In Buffett’s case, he was genuinely hoping for the stock to drop below the $35 put option strike price so that he would be assigned 5 million shares of Coca-Cola at an effective price -14% below the current market quote at the time ($39 per share when he initiated the trade).
Put option assignment or stock ownership is not always the intent of every income trader who sells naked or cash-secured put options. In most cases they are hoping to collect the income, have the put option expire worthless and move on to the next trade.
In today’s reprint of Thomas’ Rebel Income newsletter (annual subscription $1,164), he discusses why put option assignment isn’t a bad thing and how you can turn it into a very profitable trade when done right.
Week 3: Why Stock Assignments AREN’T a Bad Thing
A couple of the questions I see quite a bit from new subscribers are how are they supposed to know when to close a put selling trade I’ve written about, or how are they supposed to avoid buying the stock if it drops below their option’s strike price before expiration. I’d like to use today’s post to elaborate on these questions in more detail.
First, when I sell a put option to open a trade, I’m really looking for one of two results:
- The stock closes at expiration at or above the strike price of the put I’ve sold. In this case, the put option expires worthless. I don’t have to do anything to close the trade; I just keep the money I brought in when I sold the put and the option goes away.
- The stock closes at expiration below the strike price of the put I’ve sold, which triggers an automatic stock assignment. That means I’ll buy the stock at the strike price of the put I’ve sold.
If the stock closes below the strike price I’ve sold, I will initially be in a negative position, since the stock is lower than my purchase price.
Since the stock assignment in the second case is automatic, I also don’t have to take any additional action. My broker handles the transactional details, I pay the commission fee for the stock purchase, and the shares are now in my account. This is why I don’t write about closing the put selling trade. The put will either expire or I will be assigned the stock, and I’m okay with either result. When I am assigned a stock, I begin looking for opportunities to sell call options against it to generate more income and lower my cost basis in the stock. I like to sell out-of-the-money call options so that if I am called out, I can factor a capital gain into my profit analysis along with the income I’ve generated with the put sale and the covered calls. The covered call is the mechanism I use to “close” a stock position. My Tuesday highlights emphasize put selling first and foremost, but if I have been assigned a stock from one of my highlights and a new covered call opportunity comes along, you may see me write about it on either Tuesday or Thursday.
There is a common perception I’ve seen that thinks of put selling as a directional strategy, like buying a call – you’ll only sell a put if you think the stock will go up. The problem I have with this mindset is that it encourages you to think that a stock assignment from a put sale is something to be avoided. I get questions from time to time about why I don’t “roll” my put options from month-to-month when I’m “underwater” (a common term people seem to like to use when the stock is below the put option’s strike price, meaning that an assignment is likely) on the trade. The first answer is that I have no intention of avoiding a stock assignment; buying the stock actually gives me two ways to keep the income machine going, since not only can I look for opportunities to sell covered calls, but I’ll also be able to draw dividends on the stock if I own it through a dividend declaration.
The principle of “rolling” a naked option is something that I know a lot of directionally-biased traders believe in, because the one thing they don’t want to do is to be forced to fulfill the obligation selling the option put them under. The problem I have with that approach is that in order to avoid the stock assignment, you have to buy the put option back from the market to close the trade. Since the stock’s price will be below the strike price you sold, you will have to pay higher and eat a loss on the trade. For a trading system that centers on income generation, this process is extremely counterproductive.
I’ve written quite a bit in Rebel Income about my belief that you should never sell a put option on a stock you are not willing to own. I’ve seen a lot of traders who think that if the stock drops below their put’s strike price, they would rather just buy the put back from the market, absorb the capital loss on that trade, and move on to the next one. Hopefully, I’ve already explained the transactional problems that creates, but you should not ignore the fact that closing the trade eliminates the possibility of capital gains in the stock once it starts to increase in value again. That means that a big component of my system—which relies on covered calls—is taken completely out of the picture. Over time, those covered call trades have made up an important part of my overall success.
The difficulty, as many of you have seen, comes when the stock is several dollars below the strike price you were assigned at, and keeps dropping. Selling out-of-the-money call options is going to help you lower your cost basis sure, but the further the stock drops, the less likely you are to get any premium of real value from any strike price that is close to, much less above, that net cost. That means that to write a new covered call, you have to be willing to sell a lower strike price and run the risk of a reversal that could call you out of the trade before you’re really ready to. So what do you do?
My answer is actually pretty subjective: sometimes I’ll go ahead and write a covered call, and sometimes I don’t. While some parts of my decision-making process in this situation are based around analytics, others are based around nothing more than my gut instinct. I’ll give you a couple of examples from my historical trades to illustrate.
On November 18, 2014, I sold a put on SLCA with a strike price of $41 per share. The trade covered a month, and at expiration the stock was at $28.41. I was assigned the stock at $41 on December 19th; my net cost in the position at that point was $39.50 per share. The stock was still dropping almost in parallel with oil prices, and although the stock rallied a couple of dollars from a low around $23 in late December, it reversed again and started back down. On December 29, I sold a covered call for 18 days (expired Friday, January 16, 2015) on my shares, this time with a strike price of $29. I was taking a risk at that point, but with the strength of the downward trend, and few signs of a recovery in oil led me to believe the stock wouldn’t be likely to get above that price. Turns out I was right – the stock found a low at $27.50 before reversing.
The picture really only got worse from there – the stock dropped as low as $14 on multiple occasions and has only recently started to move up a bit, sitting at around $23 as of this writing. I’m still holding the stock because the fundamental profile still looks good and I think the upside in the stock is still there in the long-term. I sold a covered call on the stock at $41 in April 2015 when it was approaching its latest peak, which then expired worthless but helped me bring my cost basis down to a little below $37. I also made use of the extended decline to sell additional puts against the stock as a way to average my cost lower in the event of an additional assignment. Those options expired worthless, but they brought in more income that I can also use to reduce my cost basis; it is now around $35 per share. For now, I’m holding the stock and waiting for a new opportunity to write another covered call when the stock rises again to the mid-$30 level.
In December 2015, I sold two put contracts on SYNA. The first was on December 10th with a strike price of $62.50, and an expiration date only 9 days away. The stock closed on December 19th above $68, so this contract expired worthless. On the 23rd, I sold another put contract that expired on January 9th with a strike price of $67.50. The stock closed on the 9th below $61, so I was assigned the stock with a net cost of $65.65 after the assignment. On the 12th, I sold a covered call to expire on January 22nd with a strike price of $62 – once again accepting the risk of being called out lower than my actual cost. At the time, the stock looked like its downward trend would continue, or at the very least the stock should hold somewhere between $58 and $62. Instead, it rallied higher, with strong momentum that has since pushed it to new highs.
Now comes the really subjective part of this process I referred to earlier. A day before expiration, as I was looking at the stock and its current momentum and I thought about my options. First, the stock was about $1 above my $62 strike price; I could wait to get called out and absorb a loss of $3.55 per share. Second, I could buy the call I sold back from the market. The call was priced at $4.40 on the Ask, while I sold it at $.90 to open the trade, so in terms of immediate loss, there was practically no difference, numerically speaking, to sway my decision one way or another. I would have about the same amount of loss in the near term either way. What did I do?
I bought the call back. Why? In looking at this stock’s activity over the previous few days, it seemed clear that other investors agreed with my fundamental opinion that SYNA’s price at that time was a bargain, so they wanted to get in while they could. The stock was also due to report earnings on the next Thursday after expiration, and it seemed clear to me that the market was betting on positive numbers. I decided to let the stock ride for a bit and see how it played out. In this case, the result was great – the stock went to nearly $80, where I wrote another covered call that I was not called out on, then finally called me out of a third covered call trade at $81. My net gain (premiums + capital gain) in the trade for holding a two-month position was more than 24%.
So, if I were to sum up my approach? First, I’ll never sell a put option on a stock that I’m not willing to own – even if the stock drops far below my option’s strike price. Once I’m assigned a stock from a put sale, I take a case-by-case approach for each position, since no two positions are going to behave in exactly the same way. I’ve had a number of other stocks over the last several months that were assigned to me when the put expired and gave me an opportunity to get out with very nice net profits on an exercise from the next month’s covered call. In those cases, the stock’s drop below my put’s strike price wasn’t nearly as deep. It’s really not possible to apply a single method to every single case, so you have to be willing to adapt. Remember that the focus for each position you establish is on income generation; trades that facilitate that process and might help make the occasional stock assignment more cost-efficient are embraced, while trades that help you avoid the obligation of an option sale are counter-productive and more, not less costly to the system in general.
Over the last two years Thomas has outperformed investing legends such as Warren Buffett, Carl Ichan, and David Tepper, earning nearly 30% per year applying his unique Rebel Income system selling put options.
Quite frankly, his track record is unheard of in the financial publishing business. He’s closed exactly 101 trades, of which 98 have been winners with only 3 small losers.
He is the first to admit that much of his success—especially when it comes to his winning percentage—has to do with how he manages stock positions which are assigned, because the stock has dropped below the put option strike price.
To get a first-hand look at how Thomas manages his put selling trades, we’ve arranged for you to follow his picks for the next 30 days for only $9, with no obligation to continue. You’ll also receive two incredible bonus items free. Click here to get started.