Writing Puts To Acquire Stock

Posted by Bull Bear Trader | 5/06/2008 07:07:00 PM | , | 0 comments »

Nice article at the Crossing Wall Street blog about shorting puts to acquiring stocks at cheaper cost. The basic idea is that if you want to buy a stock, why not just sell puts against it, receive the put income, and then wait. If the stock goes up, you at least get the put premium as income. If the stock goes down, you capture the stock at a lower price. Of course, the immediate risks are that 1.) the stock goes up and you do not get to participate in the upward gains, other than the put premium income, and 2.) the stock goes down a great deal below your written strike price, forcing you to buy a cheaper stock for a higher price. For 1, you do give up potential gains, but are not adding negative downside risk. For 2, this certainly does involve downside risk, but if you bought the stock, you would also incur a loss, possibly more, since you probably bought at a higher price and also did not gain any option premium income to offset your purchase price. Buying the stock and placing stops would involve less risk, but given a gap down at the open, you would also not see the benefits of the stops, and would have similar risk as the put position. If the move down is slow, then monitoring of the option can reduce some of the same risk, but not all. Of course, the strategy works when long-term options are written in order to generate more income, and is obviously more profitable when the implied volatility of the option is high.

Furthermore, as mention at Crossing Wall Street:

"What makes this technique so effective is that it exploits the fact that option prices do not reflect the expected long-term growth rates of the underlying equities. The reason for this is that standard option pricing formulas, used by option traders everywhere, do not incorporate this variable. With short-term options, this doesn't matter. With long-term options, however, this oversight often leads the market to overvalue premiums. Taking advantage of this mispricing is the foundation of my strategy."
As mention in 1 and 2, this is not without risks, but in some cases the risk amounts to the same as buying the stock (without stops) on the downside, or not buying the stock as you wait for it to go lower, only to have it move higher without you taking a position. The strategy is worth considering, but of course, requires a little more monitoring than a simply buy-and-hold type strategy. Also, if you are looking to reduce/eliminate your downside risk, but still participate in any upward movement, call options might be a more manageable position.