The most important factor in value investing is buying stocks at cheap price. In fact, If you aren’t buying stocks at a discount, you aren’t really value investing. Today, I would like to introduce one of the tools that will help you buy stocks cheaper than anyone else: shorting put options.
What is an option?
There are 2 kinds of options: call option and put option. A call option is the right to buy a stock while a put option is the right to sell a stock at a certain price, the strike price, until a cert date, the expiration date. For example, say you buy a call option for stock A with a strike price of $10 and it is set to expire on May 26th, 2017. This option would let you buy stock A at $10 until May 26th, 2017 regardless of the current stock price.
The main advantage of buying an option is that it provides leverage with limited downside risk. In the example above, you can earn 100% return on an option as opposed to a 20% return in stock purchase, if the option price is $1 and the price of stock A increases to $12. The downside risk is limited because you can simply let the option expire and lose $1 if the price of stock A doesn’t go above the exercise price.
The main disadvantage of buying an option is that the time frame of investment is rather short (2 years at longest) and you can lose your money pretty easily. An option becomes worthless, a 100% loss, if the stock price does not reach the exercise price until the expiry date comes. When you purchase a stock, you can hold and wait even if the price goes down.
How can I use shorting put options in value investing?
Shorting a put option means you are selling the put option. In other words, you are selling the right to sell the stock at the strike price. If the buyer exercises the option, you are obligated to buy the stock at the strike price. In a sense, you are “buying” the stock at the (strike price – price of the put option).
Let me show you a real life example. Recently, I’ve been laying eyes on Big Lots, Inc. (BIG), a discount retailer in the U.S. The company is quite profitable and its earnings are growing. The stock has a payback period of less than 10 years and the stock is traded near its 52 week low at $48.16 per share as of March 24, 2017.
I’m interested in buying stock in the company but I’m thinking of shorting a put option instead to get a “discount”. Though there are many options of Big Lots, Inc. I will discuss the following put option in particular.
Selling this put option at $3.5 would mean that “I am receiving $3.5 to sell the right for someone to force me to buy the stock at $47.5 until Jul 21, 2017”.
There are 2 scenario in terms of return.
1. The stock price remains above $47.5 until Jul 21, 2017.
In this case, the put option would not be exercised because the stock price is above the exercise price. I get to keep the $3.5.
In a sense, I get 7.4% return on $47.5 in 4 months. About 24% annualized return.
2. The stock price becomes lower than $47.5 before Jul 21, 2017.
In this case, I keep the $3.5 but I would be forced to buy the stock at $47.5, even though the actual price is lower.
In a sense, I get to buy the stock for $44 ($47.5 - $3.5), which is about an 8.5% discount from the current stock price ($48.16).
In either scenario, I will be happy. In one scenario, I get 24% annualized return. In another, I get to buy the stock 8.5% cheaper than today’s price.
Even though I said that I can buy a stock at a discount by shorting its put option, it’s not entirely true. In the example above, say if the stock price goes to 0 before July 21, 2017, I am still forced to buy the stock at $47.5. I instantly lose $44 ($47.5 - $3.5).
I could also lose the upside potential as the stock price could go well above $51.66 (current stock price + option price) before July 21, 2017. For example, if the stock price increases to $53, I would’ve been better off buying the stock because I would have gained $4.84 ($53 – current stock price) which is more than $3.5, the money I made by selling a put option.
Sometimes you get to “buy” stocks at more than a 10% discount depending on the market situations. Even though shorting options is not a common practice and can be considered as an advanced technique, it is a very useful tool that can enhance your portfolio performance.