Did you know there’s a way of getting paid to buy stocks? It sounds ludicrous and not realistic. But quite honestly, it is very real and very much a possibility. Investors who want to take advantage need to understand options though. They also need to understand how to leverage these derivative instruments and most importantly, they need to know how to use them responsibly.
The strategy? Selling put options.
But we can’t do this blindly, for we will eventually run into trouble. Let’s start with a famous lesson, with a fund that may ring a bell: Long-Term Capital Management.
The company and its managers thought they had finally cracked the code. It may have seemed like the next Ken Griffin or Bill Benter, the almost-billionaire who built an algorithm to win every horse race. In the first year, LTCM returned 21%, followed by returns of 43% and 41% — after fees! — in the following two years, respectively.
Everything seemed fine, as the company was essentially selling bundles of deep out-the-money put options in a raging bull market. Of course, that’s not the only strategy the company engaged in, but its use of leverage helped ultimately do them in. Operating with almost $5 billion in funds, the company had assets totaling about $125 billion, good for 25-to-1 leverage.
When the you-know-what hit the fan, guess who had to liquidate, as they racked up over $4 billion in losses in four months. That margin call got ugly, with a number of big banks and even the Federal Reserve getting involved. LTCM was eventually liquidated and dissolved.
While E-Trade, Fidelity, or seemingly any other broker is unlikely to grant traders 25-to-1 leverage, the point here is simple: be careful using it.
Getting Paid to Buy Stocks
When we say getting paid to buy stocks, we’re talking about entering a short put position to create a bullish position on a particular equity or ETF. The most conservative way of doing so would be to perform the cash-secured put sale.
What does that mean? Say you’re bullish on shares of Apple (AAPL). A levered up investor may consider selling 10 of the 200 strike October puts for $1.00 apiece. That may net $1,000 in net credit — an amount the trader can keep should Apple close above $200 on expiration. However, do they realize that they are also obligated to buy 100 shares of Apple at $200 ($199 after factoring in the net credit) for each contract they sold?
That’s 1,000 shares of Apple and $200,000 worth of equity. That $1,000 we collected in net credit looks like pocket change now, huh?
For some, they can swallow that $200,000 exercise. Some may even be comfortable with it. For a large number of traders though, this sum is simply too great of a risk. Say Apple falls to $190 on expiration. We’re looking at a gross loss of $10 per share (net loss of $9 per share when accounting for the net credit). That’s a $9,000 loss should we close the position. If we exercise instead, we’re paying $199,000 for a position only worth $190,000.
Again, there are traders that can and may happily swallow this position without batting a lash. But for many, a $9,000 loss will wipe out significant capital. Whether we’re traders or investors, we both want to avoid an unsustainable hit.
Responsible Put Sales
That’s why the cash-secured language is so important. It means that we have the cash necessary to purchase the stock should the position get exercised. In the case of Apple, say we have $21,000 ready to invest in the stock. But instead of plunking all that cash down right now, we can use put sales to take our long position.
By selling, say one $210 put, we’re entering an agreement with the put buyer, saying we’re willing to buy 100 shares of Apple at $210 apiece if Apple is below $210 on October expiration. This speculator may be buying the put either as protection or an outright bet on a decline. It could also be a leg of a more complicated position. Who knows.
But in any regard, we will receive a net credit of $1.70 for taking on such an obligation. For the record, that’s almost 60% of Apple’s entire annual dividend, which pays out $2.92 per share. Say Apple stock trades higher, flat or even slightly lower into expiration. We get to keep our entire net credit so long as it at or above $210 on expiration.
Want a higher net credit? Choose a strike price closer to at-the-money. But just know, the closer it is, the more likely it is to be exercised.
Say we replicate this strategy three times over, before finally being exercised on the fourth cash-secured put sale. We’ll have almost $700 in net credit (more than double the annual dividend, assuming $1.70 in net credit for each put sale) and then will finally have a long position in Apple with 100 shares at a much lower cost basis.
That contrasts with buying the stock outright for almost $230 per share at current prices and sitting through a big decline.
Some investors will argue that this “getting paid to buy stocks” is all hype and that it’s really quite risky. That’s not entirely true. It’s true that getting paid to buy stocks isn’t someone giving us money while we simultaneously purchase shares. But it does represent investors collecting a net credit for agreeing to buy an equity stake at a predetermined price. This strategy works particularly well for stocks we want to own in the first place.
Detractors will argue that the cash-secured put strategy is risky. To that, it’s only overly risky in a few ways, one of which is using too much leverage. However, if we use the cash-secured put and plan to buy 100 shares (or in multiples of 100) anyway, then it is actually less risky.
Sticking with Apple, by agreeing to buy 100 shares at $210, our risk is actually $208.30 per share (factoring in the net credit) or $20,830 overall. The risk for those buying 100 shares today is actually about $28,000.
While a large gap-down may catch put-sellers off-guard, it’s not as if equity holders feel any better. The losses for a put-seller are only greatly exacerbated when they use too much leverage. Or when they only want to buy, say 30 shares of Apple, but sell a put representing 100 shares. That’s something to consider too.
When used correctly though, getting paid to buy stocks is an attainable strategy using cash-secured put options.