Buying stock by selling a Put option

By selling a put, the seller is essentially promising the buyer of the put that she (the seller) will buy the underlying stock at the price mentioned in the put contract.

Anyone intending to buy a stock at a her predetermined price can sell an equivalent put and wait for the option to be assigned to her. By selling a put, the amount for which the put was sold is immediately credited to her account, thus lowering her cost basis for the stock.

Consider the following scenario :
Mary wants to buy 100 shares of XYZ company at $65 dollars. She does not want to pay anything more than that. In this scenario she can do either of the following.

#1 :
She can immediately place a limit “Buy” order for XYZ company at 65 dollars and wait for the stock price to hit 65. Whenever the stock hits 65, her order will executed and her account will be credited with 100 shares of XYZ company.

OR

#2 :
She can sell a XYZ 65 Put. Because she is selling a put, the market will compensate her for making this promise to the buyer. Let’s say the “put” in consideration is being sold for $1. By selling a promise to buy 100 XYZ company’s share at 65 dollars, the market will compensate her with 100 dollars. If someone exercises the put, she will then have to give the exerciser of the put, 6500 dollars.

If she follows this approach of buying the XYZ company’s stock her cost basis for 100 shares will be 6500 - 100 (she got by selling the put) = 6400 dollars.

However, every option has a expiry date attached to it. In the event of stock price not hitting 65, nobody will exercise the put and she will not be able to buy the shares at 65 dollars. But even in this case she made 100 dollars, by selling the put at $1.

So, if you only want to buy a stock at a predetermined price and are ready to wait (which I think every investor should) then taking #2 route is much better buying strategy. If you cannot buy the share at the predetermined price, at least you get some money by selling the put.

This entry was posted on 26 Jan 2008 at 22:30 and is filed under Personal Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or trackback from your own site.