Using Options as Part of an Investment Strategy

There are many facets to using options as an investment strategy. If used correctly, options can be a useful source of income for investors or be a hedge to our investments.

Investing legend, Warren Buffett, is a fond believer of using options as part of his investment strategy and has previously publicly announced a few of his deals.

In this article, I will highlight one investment strategy using options as a mean to obtain income.

This article is also the third and final part of the stock option strategy series. In the first article, I introduced what stock call options are and in the second, I discussed put options.

Selling put options

How often have we identified a great company that we wish to invest in, only to find out that the price the stock is trading at is not what we are willing to pay for?

This can be frustrating for investors who, after hours of research, realise that the potential stock is too expensive. We then have to put this stock on our “watch list” and monitor the price. If the price comes down to the reasonable price, then we can go ahead and purchase it. If it does not, we may never buy the stock.

What if I told you that you could earn money while waiting for that stock to drop in price?

Selling put options is a great way to earn additional income while waiting for a market correction to buy that wonderful company you have been eyeing.

As mentioned in the previous article, by selling put options, you charge the buyer a premium to obtain the contract from you. You then pocket this fee regardless of the outcome of the put option contract. However, you are then obligated to buy the stock at the pre-determined strike price.

When selling put options you can decide which stock to choose, the exact strike price of the option and the expiry date of the contract. This can give you control of the variables in the deal and ensure that you only sell the contract that you are comfortable with.

Let’s take the following example.

An example of earning income through options

Mr Jay has identified Company ABC as a good company to invest in. However, it is trading at $100 per share and he feels that a fair valuation of the company would be around $90 instead. He is willing to buy 100 shares of the company if the share price falls to that price.

With this in mind, Mr Jay decides to sell a put option for 100 shares at a strike price of $90. He collects a premium for the contract. In exchange, he is obligated to buy 100 shares of Company ABC at $90 if the price falls to or below $90.

There are two outcomes for Mr Jay.

First, if the price falls to or below $90, he is obliged to buy the stock at $90, the strike price. Because Mr Jay has already determined that he wants to buy the stock at this pre-determined price, it does not make a difference to his investment strategy and the only difference is that he earned a premium while waiting for the price to come down.

If for some reason the price falls below $90, Mr Jay still has to buy the stock at $90 and would have to endure paper losses to his investment. However, he would still be happy to hold the stock, as he believes $90 was the right price to pay anyway and that the stock price should be way above $90 in the long-term.

The other outcome is if the price remains above $90, the contract is not executed and Mr Jay simply pockets the contract premium, which the buyer paid him. Mr Jay will be happy with either outcome because of his underlying willingness to buy the stock for the long-term.

The Foolish bottom line

Options may have had a bad reputation in the past, with traders and speculators making use of options to leverage or as a means of obtaining a quick buck through price volatility. This can sometimes lead to embarrassment and painful losses.

However, if we look more closely at stock option mechanics, we can see that there are ways long-term investors can make use of them. This could be to earn income or as a way to hedge our investments.

Selling put options is just one way that investors can make use of derivatives as part of our long-term investment strategy. Having said that, it is always important to fully understand every instrument you are investing in before deciding if it is the right method for you.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.