Markets have rallied above key moving averages, driving up the price of stocks across the board. Yet, instead of chasing the price advance, you could wait for a price dip to enter.
Alternatively, you do not have to wait for a stock to retrench to buy. Instead you could write put options on a stock for which you feel the upside is limited and that you want to buy on a decline.
When you write or short a put, you assume the legal obligation to buy a specific number of the underlying stock at the strike or exercise price for a specified length of time until the expiry date of the contract. To compensate you for the risk of exercising, you receive a premium from the buyer of the put option. After the expiry date, should the particular option expire worthless, you as the writer of the put retain the premium. This is a straightforward option strategy.
You may want to write a put under two scenarios:
You are bullish on a stock and believe it will trade above or near the strike price during the life of the put option. You could generate some premium income through writing put options and hoping they’re not exercised.
You want to purchase a particular stock at a price that is below the prevailing market price of the stock. If exercised, the put writer buys the stock at the strike price and, if not exercised, the put writer retains the premium. I will assume you are in this camp.
Let’s say you like Cisco Systems, Inc. (NASDAQ/CSCO), but want to buy at a cheaper price than the prevailing $23.30 as of July 27. Let’s say $20.00. You could short the Cisco September $20.00 Put option set to expire on September 17. If Cisco falls to $20.00 or below, the put would be exercised and you would be required to buy Cisco at the strike of $20.00, which was your objective. However, remember that you also get to keep the $0.22-per-share premium for writing the put, which equates to $22.00 per contract.
If Cisco falls to $19.95, it is likely that the put would be exercised. You buy at $20.00, but given the $0.22-per-share premium, you receive, your adjusted average cost would be $19.78 per share. At the end, you would get a position in Cisco at a price that you want. The risk here is that, should the price of Cisco fall even further, say to $18.00, you would be down $1.78 a share. The key is for the stock to hold and then rebound; otherwise, you would find yourself in a negative position.
Under this scenario, you want to buy a particular stock at a price that is below the prevailing market price of the stock. This strategy is often referred to as a cash-secured put.