If there is one lesson that investors should learn from market history over the past several decades, it is that the best time to buy stocks is when the market is tanking. Unfortunately, very few have the conviction to buy in the middle of a wave of panic selling.
If making a complete commitment to buy is not in the cards for you, then one option strategy—selling puts—provides an alternative. Selling puts may actually be easier for the individual investor to stomach.
- Historically, buying stocks during a downturn has been very profitable, but many investors just can't do it.
- Selling put options during a downturn is a lower-risk alternative to buying stocks.
- The high volatility of bear markets makes selling options more profitable than usual.
- Less experienced investors should only sell puts on stocks that they would be comfortable owning.
- This type of strategy has been successful enough that put selling ETFs are now available for the S&P 500.
Buying in a Downturn
Market history suggests that a contrarian approach works better. After the bear market in the early 1970s, buyers were rewarded. Investors made lasting gains by buying during a severe recession in the early 1980s. After the financial crisis of 2008, stock buyers won big over the next decade. Within months of the crash of 2020, many investors made record gains in record time. Fifty years from now, the story is likely to be the same.
Basics of Put Options
A put option gives the buyer of that option the right to sell a stock at a predetermined 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 predetermined price. Notice the difference in buying and selling puts: when you buy a put, you 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 out-of-the-money at $60, you can simply let the option expire and only lose the premium paid.
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 one sense. You are entering into a contract where you have an obligation, rather than a right to buy the stock. This information should be well-known to investors who have studied options basics.
Put Selling in a Downturn
When markets are declining, selling put options can be an excellent tool even for the individual investor. However, one must know how to sell puts intelligently. When stock prices fall, they often do so rather quickly. That leads to an increase in volatility, which in turn increases option premiums. This increase makes sense because options face time decay, so having a stock price that moves quickly is what option traders want.
Selling options when there is more volatility implies that sellers will get a higher price due to the increased premiums. Sophisticated options traders like to sell puts in hopes of pocketing the premium income. However, long-term investors should look at selling put options as a way to buy shares in businesses that they like at a lower cost. Legendary investor Warren Buffett has used similar strategies in the past.
While buying options in the hopes of quick gains is associated with speculation, selling options often works well for investors.
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. This type of strategy has been successful enough that put selling exchange traded funds (ETFs) are now available for the S&P 500.
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 income from the sale (500 shares at $3 each). For purposes of this article, we will ignore commissions because they are often low, although they should still be considered. Since you wrote this option, you must buy 500 shares of XYZ at any time until expiration for $45. If you must buy the stock, your net costs without commissions will be just $42 a share because of the option premium income.
By selling the put, you went from putting up $25,000 to buy the shares to collecting $1,500 in premiums. If shares in XYZ declined below $45, you would have the shares "put" on you. However, 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 a sure thing. If shares in XYZ or any company that you sell put options on decline significantly, you will still be sitting on losses. Option premiums will just reduce the losses. Conversely, suppose the stock price continues to go up. Then, the put seller will miss out on further upside that could have been achieved above and beyond the option premium.
Selling Puts Intelligently
Because they are derivative instruments, the buying and selling of options should be handled with extra care. The sale of a put firmly obligates you to buy the underlying stock, so only sell puts on stocks that you would be comfortable owning. Some plans include the seagull option strategy.
For the vast majority of investors, selling puts should only be considered as a way of potentially buying shares down the road. Let earning the option premium be a fallback if you don't get a chance to buy the stock for less. This type of thinking will significantly reduce the probability of selling puts for the wrong reasons and losing money.