Averaging down by writing puts

In this blog post we will talk about an options strategy you can use to either average down on a current position or get a discount on a stock you plan to buy. This is a very effective strategy when you feel a stock is undervalued but the market is acting irrationally on it.

Introduction

Typically when an investor wants to average down to lower his average price paid the investor will wait for a dip and then buy. The strategy we are about to discuss works in much the same way but generates higher returns while getting you even better bargains.

Selling a put

A put option is a contract granting the buyer the right to sell a security from now until a future date at a specified price (the strike price). When you write a put option you are basically agreeing to buy someone else’s shares at a specific price no matter what.

So how does that help us when averaging down? Simple. Lets say company XYZ is trading at $10 a share but you don’t want to go all in given that the price has risen fairly quickly and you’re worried it may come down. One thing you can do is buy half of your intended position and write a put contract for your other half at a lower price you feel more comfortable buying in. So lets say you plan to buy 200 shares over the next 3 months with this strategy you could buy 100 right down and write a put contract on the other 100 agreeing to buy at that price if the price falls. In exchange for granting someone the right to sell to you at that strike price you collect a premium or a small return. Lets say you wrote a put contract agreeing to buy XYZ within the next 3 months if the price falls below $7. You receive a $5 premium ($5 x 100 = $500) What this means is that if the price falls below $7 you will now get those shares not only at $7 a share but rather at $2 a share given the $500 premium received. ($7 x 100 = $700 minus the $500 premium collected this means you get 100 shares for $200 total or $2 a share) While a premium that high may e unlikely in options the concept still applies. You will get a better discount on your trade when averaging down using spit option.

Optimizing the strategy

One way to optimize this strategy is to write all the puts for all the shares you plan to buy near the support level of a moving average (wether the 20 or sometimes more effectively the 50 or 200 day moving averages) This will allow you to buy at the bottom of any downtrend that may occur at an even better price.

Conclusion

This a strategy is great to use when looking to buy a new stock or average down on a current holding. If the stock doesn’t reach the price where you hoped to buy at least you get a small return from writing the put option.

Posted Saturday, November 17th, 2012 under Options.

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