If there is one lesson that investors should learn from market history over the past several decades, it's that the best time to buy stocks is when the market is tanking. Unfortunately, very few have the conviction to buy amidst a wave of panic selling. Yet market history suggests otherwise. After the bear market in the early 1970s, buyers were rewarded. In the early 1980s, buyers were rewarded. After the tech bubble of 2000, buyers were rewarded. Fifty years from now, it's likely the same will be true.
If making a complete commitment to buy is not in the cards for you, then one option strategy - selling puts - provides an alternative method of doing so that may actually be easier for the individual investor to stomach.
The Basics of Put Options
A put option gives the buyer of that option the right to sell a stock at a pre-determined price known as the option strike price. Buyers of put options are making bearish bets against the underlying company. The price you would pay for that put option will be determined, among other things, by the length of time you want the option to last. The longer the time, the more you pay.
When selling put options, the reverse is true. A seller of put options is taking on the obligation to buy the underlying stock at a pre-determined price. Notice the difference in buying and selling puts: when you buy a put, you merely have the right to sell the option. If you don't want to sell the stock at the option strike price of $50 because the shares are trading at $60 (out-of-the-money), you can merely let the option expire and only lose out on the premium paid.
However, when you sell a put you are required to buy the shares if the buyer of the puts decides to sell them. So in selling put options, the risk is magnified only in the sense that you are entering into a contract where you have an obligation, not merely a right to buy the stock. (For more see our Options Basics Tutorial.)
Why Put Selling Can Be Great in Declining Markets
When markets are declining, selling put options can be an excellent tool even for the individual investor as long as one is clear on how to sell puts intelligently. When markets decline, they often do so rather quickly leading to an increase in volatility, which in turn increases option premiums. This makes sense because options are time-based instruments, and having a stock price that moves quickly is what option traders want.
Clearly then, selling options when there is more volatility implies that sellers will get a higher price due to the increased premiums. While sophisticated options traders like to sell puts in hopes of pocketing the premium income, novice traders should look at selling put options in order to create a way to buy shares in a business you like at a lower cost basis. (To learn more about the dangers of uneducated option trading, see Naked Options Expose You To Risk.)
The best time to buy stocks is when markets are declining. Yet many investors simply don't have the emotional wherewithal to do so. Selling puts is one way to alleviate the problem.
Let's say you're a fan of Company XYZ, but you're still on the fence about what the market is going to do. You would like to own 500 shares in your portfolio. With a current price of $50, that will cost you $25,000. Instead you can sell five put contracts (one contract = 100 shares). For example, you could sell next month's $45 put options on XYZ for approximately $3.
By doing so, you will pocket $1,500 in premium from the sale (500 shares at $3 each). For purposes of this article, we will ignore commissions, although they should always be considered in any trade. By writing this option, you are obligated to buy 500 shares of XYZ at any time until expiration for $45. But because of the premium you collected from writing the option, if you are required to buy the shares, your net costs excluding commissions, will be $42 a share.
By selling the put, you went from putting up $25,000 to buy the shares to collecting $1,500 in premiums. If shares in AAP declined below $45, you would have the shares "put" on you, but your cost basis is $22,500 less the $1,500 you collected in premiums, or a net cost of $21,000.
Of course selling puts is not that black and white. If shares in XYZ or any company you sell put options on decline significantly, you will still be sitting on losses, although they will be mitigated by the option premium. Conversely, if the stock price continues to go up, you will miss out on further upside that could have been achieved above and beyond the option premium.
Sell Puts Intelligently
Because they are derivative instruments, the buying and selling of options should be handled with extra care. Because the selling of a put firmly obligates you to buy the underlying stock, ONLY sell puts on businesses you know and would be 100% satisfied owning.
For the vast majority of investors, selling puts should only be considered as an outlet of owning shares down the road not as a way to earn additional income via premiums. Let earning the option premium be a fallback if you don't get a chance to own the stock for less. An approach with this type of thinking will significantly reduce the chance of selling puts for the wrong reason and thus losing money. (To learn more, see Using Options Instead Of Equity.)