A Better Way to Own Stocks Instead of Placing Limit Orders Essay
Before discovering stock options, I thought that the only viable way to purchase stocks through a brokerage account is to place a buy limit order. This is done by setting the number of shares to be purchased at a specified price.
Selling a cash-secured put can effectively achieve the same, but you are able to purchase stock price at a discount compared to using a limit order. This is due to the up-front premium given when making the commitment to purchase the stocks at a specified strike price.
Before going into the details, you will need to first understand what is a put option and how it works.
What is A Put Option?
A put option is a contract that gives give the buyer the right, but not the obligation, to sell an agreed amount of stocks at a specified price (known as the strike price) by the expiration date.
The buyer of a put option for will pay an up-front premium to the option seller. The option seller gets to keep the premium, in return for bearing the risk to purchase the underlying stock at the strike price should the price of the stocks decline below the strike price. Each contract corresponds to 100 shares of the underlying stock upon expiration.
Selling a cash-secured put of an underlying stock simply means that one should have sufficient capital to purchase the stock, in the event of a stock assignment.
For instance, if you sell 1 put option contract for Apple Inc. (NASDAQ: AAPL) at a strike price of $180, you should have at least $18,000 ($180/share x 100 shares) available in your brokerage account.
Conventional Approach: Buying Stock Using Limit Order
A common way to purchase stocks is to place a buy limit order in the stock brokerage. Let’s say I am interested to buy 100 shares of Apple Inc., which has a price of $193.53 per share at the point of writing (19 Nov 2018). I feel that the stock is not attractive at the current price and determined that $180 will be a great entry price to own the stocks.
I placed a $180 limit order for 100 shares. As long as the limit order is active (you can set an expiry date), the order will be filled whenever the price of the stock decline to $180. Using Interactive Brokers, the commission for purchasing 100 shares of a stock is $1.00. The effective cost of owning 100 shares of stocks for Apple Inc. is $18001, or $180.01 per share.
Alternative Approach: Selling a Cash-Secured Put Option
Instead of placing a buy limit order, I can sell a cash-secured put option instead. Similar to the above example, I am looking to purchase Apple Inc. at $180 per share. I sold 1 put option contract at a strike price of $180 expiring on 21 Dec 2018 (33 days to expiry). For making this commitment, I receive $2.40 in premium per share, for a total of $240 ($2.40/share x 100 shares). The commission for selling the put option using Interactive Brokers is $1.00.
If the price of the stock is above $180 by the expiration date, the put option will expire worthless and I will get to keep the premium and achieve a profit of $239. However, if the stock gets assigned, my effective cost for owning the stock is reduced to $17,761, or $177.61 per share.
Issues With Selling Cash-Secured Puts
Owning a stock through selling a cash-secured put option is not without disadvantages. Here are some of the potential issues that I have identified:
- You May Not Own The Shares
If the put option contract expires worthless at the expiration date, you will not be assigned the stocks. This is unlike selling a limit order, where the stocks will be purchased if shared are trading at or below the set price for the limit order.
- Minimum Assignment of 100 shares
When dealing with stock options, you will have to work with round lot as each option contract corresponds to 100 shares. This means if you have limited capital, you can only afford to sell a cash-secured put on stocks which are lower in price. Stocks such as Amazon (NASDAQ: AMZN) which has a stock price of more than $1,500 will likely be out of reach for most investors.
- No Dividend During Contract Period
If the stock distributes a dividend during the option contract period, you will not be eligible for the dividend as you do not yet own the stock. For a limit order, you can control when you want to own the stock and be in time to collect a dividend payment.
Despite some of the disadvantages, selling a cash-secured put on an underlying stock can be a brilliant way to get paid while waiting to own the stock at a price you would be happy with. The premiums received help to reduce the effective cost of owning the stock, reducing your loss when the stock price decline and increasing your returns when it rebounds.