Imagine walking into your favorite shop and noticing a sign that reads: “20% off Specially Marked Items”…not only that, there’s a part underneath that reads: “And we’ll pay for it, too“
Well, the above is unlikely to happen at your favorite shop; however stock market offers such opportunities.
How? Read below to find out
For the moment wear the hat of an investor and assume that you like HDFC Bank and wish to own its shares; however you want to buy them at 550 and not at the current price of 600. This could be because you are either expecting some correction in the short term or you have done some calculations based on which you don’t want to pay a price higher than 550.
Note: HDFC Bank is just being used as an example. Do not consider this note as buy/sell advice on HDFC Bank.
Most investors would simply sit on the sidelines and wait for the price to fall to 550…but you know what, there’s no reason to sit on the sidelines because you can still generate some income on your portfolio while waiting for HDFC Bank to correct to 550 and that’s by Selling Put Options (here I am assuming that you are aware of the basics of call/put options).
After reading the three words “Selling Put Options” most readers are likely to stop reading further as the very thought of options and that too selling options is complicated and scary for them.
For the moment unlearn what all you know about options (except the basics) and try and incorporate “Selling put options” strategy to earn some money on your favorite stock till it reaches the price you want to invest at.
How can you earn money while waiting for HDFC Bank stock to correct to 550?
At the moment HDFC Bank stock is trading at 600. The put option with a strike price of 550 and an expiry date of 31st Oct’13 is currently selling at a premium of 8.5 per share. The market lot for HDFC Bank is 500.
On selling 1 put contract with a strike price of 550, you will pocket net premium of Rs 4,250 (lot size 500 X 8.50 premium) minus brokerage cost (for the sake of simplicity, we will be ignoring brokerage cost). The premium of Rs 4,250 will actually get credited in your trading account.
Of course, for entering into the above trade you will have to maintain some margin with your broker (45,000 in this case) but that’s only till the time you square of the option contract or maximum till the expiry of option contract (31st Oct’13).
Come 31st Oct’13 and HDFC Bank is still trading above 550, the put option with strike price of 550 being out of money will expire worthless and you will pocket net premium of Rs 4,250. Since you didn’t want to buy HDFC Bank shares above 550, you won’t buy a single share while still get paid for trying and waiting for it to correct to 550.
If HDFC Bank corrects to 550 or lower i.e. the price at which you wanted to own the shares of the bank, you can square of the option contract (the premium at the time of squaring will depend on the number of days left to expiry of option contract and the amount by which HDFC Bank is in the money i.e. lower than 550) and buy the shares of your favorite stock from the cash market.
The above strategy can be refined further for those interested in pocketing only the premium and not so much in buying the shares of the company…but we will leave that for some other post.
Why is the above strategy not risky?
Some investors/traders are put off by the very thought of selling options as they have been trained to think in terms of limited profit and unlimited loss.
However selling put options is no riskier than buying shares outright. When you buy shares, the risk is that you lose your entire investment. When you sell a put option, you’re obligating yourself to buy shares, too… but at a much lower level than the current share price. And if you do end up buying the shares, your risk will be the same as a regular shareholder.
The difference is that nobody pays you cash to buy stocks outright – but they do when you sell put options. Selling puts is just another way to invest using the options market.
Some constraints with the above strategy
If the stock price is too far out of money, say 650 (against current price of 600) against the price you want to invest at i.e. 550, the premium may not be sufficient to churn out reasonable amount on the margin and brokerage involved.
At the moment we do not have options with expiry dates 2-3 years ahead (LEAPS), else the strategy of selling put options for pocketing premiums could have been even less riskier with an additional factor of earnings growth of the company.
There are just a few scrips in the F&O segment, mostly the large caps; so the ones who invest in small and mid caps may not find any company of their liking for executing the above strategy.