Learn These Two Rules Before Using This Powerful Strategy
Editor's note: Many investors have misconceptions about trading options...
But if used correctly, they can actually be less risky than buying stocks outright.
We're once again turning to Enrique Abeyta, an editor at our corporate affiliate Empire Financial Research, for today's Masters Series essay. In it, he shares another example of this strategy at work and details two important rules to keep in mind with options...
Learn These Two Rules Before Using This Powerful Strategy
If you're a retiree – or simply planning for your upcoming retirement – you're probably a big fan of the "Dividend Aristocrats."
This is the elite club of large-cap, blue-chip stocks that have raised their dividends annually for at least 25 years in a row.
Many of these companies make products that you use every day – like Post-It sticky notes from 3M (MMM), toothpaste from Colgate-Palmolive (CL), tools from Stanley Black & Decker (SWK), and soft drinks from Coca-Cola (KO).
For many folks, these stocks should be the bedrock of your retirement portfolio. They've all steadily increased their dividends for the past half-century... And if I had to bet, they'll still be around when your grandkids have grandkids of their own.
If you're extremely risk-averse, you could even go out and buy the Dividend Aristocrats with a single click through an exchange-traded fund like the ProShares S&P 500 Dividend Aristocrats Fund (NOBL).
But you might be surprised to learn that this stodgy group of stocks considerably underperformed the broad S&P 500 Index over the past year. Take a look...
I'm probably going to get a bit of flak in the mailbag for what I'm about to say next...
Dividends suck.
I know, I know... That probably goes against every piece of investing advice you've ever heard. After all, investing legend Warren Buffett's biggest stakes are in dividend-paying stalwarts.
But as I said yesterday, even Buffett has used a different, more powerful strategy to generate income in the markets. He personally used this strategy to make $5 billion during the previous financial crisis back in 2008 and 2009.
It's a little-known strategy that allows everyday investors to generate far more income than dividends without ever having to buy a single share of stock.
It's called selling put options.
In yesterday's essay, I explained how this works using a simple analogy. As I wrote...
Say you walk into a clothing store and see a nice sweater on the rack. It costs $50.
You love buying great-quality sweaters at good prices, but you think you can get it for an even better price.
You know that retail in that area hasn't been doing so well, and there's a chance that the prices of the store items could continue to come down.
You go to the store owner and say, "If that sweater goes on sale, I'll buy it for $40 two months from now."
You assure him that your offer is good any time over the next two months, no matter what happens... even if the price of the sweater falls below the $40 that you offer him.
The store owner agrees to your offer, and hands you a $5 bill. He's grateful that he'll be able to sell the sweater to you for at least $40 any time over those next two months.
Not bad, right? You're getting paid to do something that you'd willing to do anyway.
And that means you've effectively sold the cashier a put option.
You (the put seller) decided to enter into a contract with the store owner (the put buyer) that gave him the right, but not the obligation, to sell you the sweater for $40 sometime in the next two months. In return for this agreement, he paid you $5 – which you keep no matter what happens.
Let's take a look at Starbucks (SBUX). You could go out and buy 100 shares of the iconic coffee-shop chain for around $105 each. And over the past year, you would have collected $172 in dividends.
Of course, last year, you would have also had to stomach a 35% pullback during the depths of the COVID-19 crash from mid-February to late March.
Now, consider this... Instead of buying 100 SBUX shares, you could sell a single put option (which controls 100 shares) that expires in less than two months and collect $475 – more than two and a half times more money in about one-sixth of the time.
Would you rather make $172 in a year, or $475 in about two months?
I don't know about you, but the answer seems pretty obvious to me...
That's why last year, as I was preparing for the launch of my brand-new options-trading service Empire Elite Options, I recommended a dozen put-option trades on world-class businesses. In each instance, our put expired worthless... and readers who took my advice got to keep the premium without ever touching a single share.
By selling a single put option, readers who followed my advice were able to collect $471 on insurance giant Allstate (ALL)... $1,000 on pizza chain Domino's Pizza (DPZ)... $1,500 on athletic apparel maker Lululemon Athletica (LULU)... and $2,150 on streaming giant Netflix (NFLX).
Of course, I can't guarantee 100% success going forward. (In fact, I can guarantee we won't have a 100% hit rate!) But what I can tell you is that over my 20-plus years on Wall Street, working alongside some of the greatest investors of all time, I've fine-tuned my options-trading strategy to not only identify world-class businesses, but find the absolute best setups in stocks.
The key to this strategy is employing it at the RIGHT time in the best of these situations...
Let's take iPhone maker Apple (AAPL), for example. The company produces some of the most iconic and widely used products around the world, has a mountain of cash on its balance sheet, and posts annual revenue of more than $270 billion.
You like the stock enough that you could go out and buy shares today at around $130... But you'd be thrilled to own it at $120. You could wait for AAPL shares to fall to $120 and then buy them at that price... but if it never gets there, you're left empty-handed.
Selling puts is a much smarter way to execute that trade.
Instead of hoping that the stock will fall, you could enter into a contract with a buyer to agree to buy AAPL shares for $120 over a certain time period, let's say up to a month from now.
In exchange for entering into that agreement, you collect a premium from the option buyer. In this specific case, the market has priced that at $3 per share.
You've just sold a put option to a buyer that obliges you to buy shares of AAPL for $120, even if shares drop below that price.
But in return, you collected $3 per share... and you got the chance to buy the stock at a price that you wanted in the first place.
One important quirk to mention here... One options contract controls 100 shares of the underlying's stock. When you sell one contract, you're agreeing to buying 100 shares of Apple, and if the contract is priced at $3, you actually receive $300 of income per contract.
This could play out in one of two ways over the next month...
- Apple stays at or above $120 per share.
Nobody would agree to sell you 100 shares of AAPL at $120 if he could sell them on the open market for more than that. So the option the buyer purchased from you expires worthless, and you keep the $300 you were paid when you sold the contract. Then, you can turn around and sell another put option and collect another $300 or so.
- Apple falls below $120.
The great thing about put-selling is that even if the stock declines by a certain percentage, you still make money. As per the contract, you're now obligated to buy 100 shares of Apple from the option holder for $120 each. You spend $12,000 to buy them.
However, you still get to keep the $300 premium that you received when you sold the option. So, your true cost is actually $12,000 - $300 = $11,700. In other words, as long as the stock is trading above $117 per share, this trade is still profitable.
Would you rather buy the stock at $130, or get paid $300 to buy the stock at $120? To me, the choice is clear.
One way to use put options is if you think the stock will go up... The put option expires worthless and you simply keep the "premium" you received up front. On the other hand, with a longer-term perspective, you might be interested in buying a stock but want to do so at a lower price than where shares are currently trading.
Selling put options on companies that you're willing to buy gives you an option to collect cash up front and then buy shares of the company if the price drops. By selling the puts, it lowers your cost basis if you're obligated to buy shares, because you get to keep the premium you received up front for entering the agreement.
With this in mind, we follow a couple of general rules...
- Never sell puts on stocks you wouldn't want to own outright.
Remember, selling puts obligates you to buy the stock at a predetermined price from the option buyer if he decides to exercise the option.
That means if the stock price falls below the strike price at which you sold the option, you will have to buy those shares.
For this reason, only sell puts on stocks you would want to own in the first place.
The last thing you want is to be stuck with a stock of a low-quality company that you wouldn't be interested in buying.
- Never sell more put option contracts than you can afford.
Again, when you sell puts, you have an obligation to buy 100 shares per contract of the underlying stock if the option buyer exercises his option. That means you'll need to have enough cash in your account in case you need to purchase those shares.
When you sell one put option and the buyer exercises, you have an option to buy 100 shares of the underlying company. If the strike price of the put option is $50 and you sell one contract, that's $5,000 that you need to have on hand.
Hopefully, things are starting to become clearer...
As I've explained this weekend... done right, selling puts is a phenomenal way to get paid to buy the stocks you like. And that's why it's one of the most powerful trading strategies I've ever come across.
Regards,
Enrique Abeyta
Editor's note: By using Enrique's approach, you could have collected $785 up front on Apple... $310 on drugmaker Pfizer (PFE)... and $730 on home-improvement retailer Home Depot (HD) since the start of 2021 – without ever buying a share of their stocks.
With this strategy, you know exactly when you're in and when you're planning to get out. Plus, Enrique employs a "twist" that could end up substantially increasing your gains over time... even if the original trade doesn't go your way.
He's sharing this technique in a brand-new presentation – and he'll even walk you through a sample trade. Get the full details right here.