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Is selling puts a good way to enter a stock? Thanks, J.W.
: Selling a put to enter a stock position is more than just a good strategy, according to
experts. It's an all-around win-win situation.
James Altucher, hedge fund manager and
contributor, counts only two outcomes from selling puts, and both are favorable.
"In the first scenario, the stock remains above the strike price of the option, the option expires worthless, and we pocket the money we get from selling the option," says Altucher. "In the second scenario, if the stock price falls below the option's strike price, you get "put" more shares -- meaning you're obligated to purchase them -- but at attractively low prices. That's not a bad proposition, because you like the stock anyway, right?"
Right. But you darn well better like the stock, because if it crumbles -- and no stock is immune from crumbling -- you will be put those shares at the strike price. But even in that case you would be better off, since the option premium defrays the cost of being put the stock.
Confused? Don't be. Here's an example, provided by
options expert Steven Smith, using our old favorite stock, XYZ.
Assume that XYZ Corp. is trading at $47, and you could sell the August $45 put for $1.50 a contract (Each contract represents 100 shares). The breakeven, or effective, purchase price is $43.50, which is 7.4% below the $47 share price.
If XYZ shares are above $45 on the expiration day, you can reap a maximum profit of $1.50 a contract. Note that this maximum profit is achieved even if XYZ declines by 4.2% to $45, or if the shares double to $94.
"If the shares really take off, you'll have left a lot of money on the table. Therefore, selling puts might not be the best strategy for stocks that have the potential to shoot higher in a short time frame," says Smith.
But let's assume XYZ shares remain at $47 and the August put expires worthless. What did this trade return? An often-used calculation is dividing the premium collected by the share price -- in this case that would produce a yield of 3.2% over the seven weeks, or about 23% on an annualized basis.
"Selling puts creates a moderately bullish position in which the maximum profit, no matter how high the price of the underlying shares rise, is limited to the sale price of the put," says Smith. "And if the underlying price falls below the put's strike price, it also reduces the effective purchase price if the short put is assigned."
Smith also points out that while covered calls are often touted as a conservative strategy and a great way to generate income, selling puts has the same risk/reward profile as a covered call. The only difference is in the margin requirements.
"If you already own stock you can sell calls against it without additional capital as the long stock is collateral against the short calls," says Smith. "But if you are establishing a new position, selling puts is actually lower-requirement and therefore will provide a better return on investment."
What exactly do stock commentators mean by "fair value" and how is it determined? Thanks, E.M.
The "fair value" term that is tossed around in the media refers to the relationship between the futures contract on a market index, like the
, and the actual value of the index. You may hear it on
before the bell to give an indication as to how the market will open: If the futures are above fair value then traders are betting the market index will rise. If the futures are below fair value then they think the market will drop -- at least out of the box.
As to determining fair value, a professor at Vanderbilt University named Hans Stoll derived a formula for calculating it. According to
HL Camp & Co., Stoll's formula boils down to the following: "Fair Value is the value of S&P 500 Index, plus the interest I pay my broker to buy all of the stocks in it, minus all of the dividend checks I get from those stocks."