For the sake of illustration, let’s assume that you are an investor who has been following the stock of consumer goods giant, Clorox (CLX). You notice that it has fallen hard in 2018, from a high of $150 per share to $114.88. After careful fundamental analysis, you determine that Clorox would be an excellent purchase at $100 per share.
At this point, you can all your broker and place a good until cancel order to purchase Clorox at $100 per share. Let’s assume you are willing to buy 2,000 shares for a total of $20,000. If Clorox never hits $100 per share, you will never purchase the stock.
Alternatively, you can sell a put on Clorox and commit to purchase the shares at $100 per share at some point in the future. As the seller of the put, someone will actually pay you money today, and that money is yours to keep. For example, as of April 20th, 2018, Clorox has a July 20th put with a strike price of $100 that is trading for $1 per unit.
Following through on our example, you proceed to call your broker and instruct he or she to sell 2,000 Clorox puts for $1 per unit for total proceeds of $2,000. This money is deposited into your brokerage account immediately. It is yours to keep regardless of where Clorox stock may be on July 20th, 2018. If the stock is above $100 per share on July 20th, 2018, the option contract expires worthless and you pocket $2,000. That’s $2,000 more than the alternative, which was to place a good until cancel order to purchase the shares at $100.
On the other hand, if Clorox is $100 or lower, you will be required to buy 2,000 shares of Clorox at $100 for a total purchase price of $20,000. Notice that your breakeven price is lowered by the amount of the put option premium received of $1 per unit. Specifically, your breakeven will be $100 purchase price minus $1 put premium received or $99 per share.
Selling puts to establish positions in long term investments can be a great way to instill discipline in the investment process. As demonstrated in the above example, it is also a great way to add to portfolio returns through time through the systematic collection of put premiums.
Please note, this example is for educational purposes only. It is neither a recommendation nor solicitation to purchase Clorox stock (CLX).
This guest post was written by Thomas McDevitt, CFA, CFP, EA. All opinions are his own. The above references an opinion and is for educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice prior to making investment decisions.