People Really Pay For Those Things?
That's the question I always get when I explain the strategy of put-option selling to my friends.
Why would they ask me something like that?
Consider this scenario:
A brand new 2019 Mercedes-Benz E 300 4MATIC series sedan will run upwards of $65,000.
What if someone offered you $1,000 cash upfront to buy that vehicle for $10,000? Would you?
It's a weird offer I know, and you'd be skeptical, I'm sure.
But what if it was legit and there were no strings attached and there was nothing wrong with the car. You would even get the manufacturer's warranty to give you peace of mind.
Now it sounds more intriguing, right?
The question you would probably ask is - why would someone make me an offer like that?
Well, as far as I know, offers like that don't exist in the car industry, but they do it exist in the stock market all the time.
Consider this actual scenario that really happened...
In 1993, Warren Buffett wanted to buy shares of Coca-Cola (KO). At the time, it was trading for $39 per share.
Buffett decided that $39 was too expensive. He only wanted to pay $35 per share.
What were his options?
1. He could wait to see if KO would drop to $35, which there was no guarantee it ever would.
2. He could sell a $35 put option contract that would obligate him to buy 100 shares of KO at $35 each, while receiving an upfront cash payment in exchange for his agreement.
By choosing option #2, someone would actually give him an upfront cash payment to buy shares of a company he wanted to buy at the price he wanted to buy it for.
It's just like trying to buy the new Mercedes at a vastly reduced price, but yet someone would pay you to do it.
So how did Buffett's trade turn out?
Well, since he wanted to buy 5,000,000 shares of KO at $35 per, he ended up selling 50,000 put option contracts (each option contract = 100 shares of stock) for $1.50 each.
With the $100 option multiplier, he received $150 ($1.50 x 100) for every put option contract he sold.
By selling 50,000 put option contracts, he received a whopping $7.5 million dollars. Yes, $7.5 million!
That's $7.5 million he gets to keep regardless of whether he has to follow through and buy the shares of stock. Money in the bank!
With this agreement, the only way he would be able to buy shares of KO at $35 is if KO actually fell to $35 (from $39) by the time the option contracts expired (all option contracts have an expiration date).
In the end, shares of KO actually went up from $39, not down, by the expiration date.
And although Buffett didn't get to buy his 5,000,000 shares of KO at $35 per, at least he walked away with $7.5 million in his pocket.
Pretty sweet consolation prize.
This is why you need to sell put options like we do at Smart Option Seller.
We pick quality stocks we want to buy. But we don't want to buy them at their current market price.
We decide on a cheaper price to buy them which equates to a level of extreme value.
We then sell put options that match our desired buy level and we get paid cash upfront for our agreement.
Most of the time the stock never falls to our desired buy level, so we just walk away with the cash in hand (like Buffett) and move on to the next trade.
It's an income producing strategy that we repeat over and over again multiple times throughout the year on multiple stocks.
And in the off-chance that we end up following through on our agreement to buy the shares, we could watch it rally and reap unlimited reward potential.
Consider this scenario:
Walmart (WMT) is trading for $97.59 per share. Would you like the opportunity to buy it for $47.50, more than half off its current price? And get paid cash upfront, as well?
Take a look at its current stock chart below:
This is a 5-year chart of WMT going back to March 2014. You can't even see the $47.50 level it's such a low price.
Like many savvy investors, you should be jumping at the chance to buy the biggest physical retailer on the planet for more than half off its current price.
If WMT hasn't been below $47.50 per share in over five years, why would you think it would fall that far in the next ten months?
What you see above is a sampling of WMT put-option contracts that expire on January 17, 2020 – roughly 10 months from now.
I’ve circled the current bid and ask prices for the $47.50 strike put options.
The strike price represents the level in which you would potentially trade WMT shares with the other person.
And what else does it tell us?
It tells us that someone is willing to pay approximately $0.15 per contract (splitting the bid/ask) for that put option.
Since each option contract is worth 100 shares of stock, you’d get an immediate infusion of $15 ($0.15 x 100) into your account from the put option buyer as soon as you make the sale.
If you sold five contracts, you’d get $75. For 10 contracts, you’d get $150 (and so on).
But why is this important?
Because anyone buying those $47.50 put options is predicting that WMT will fall to $47.50 per share by January 17, 2020.
And when someone wants to speculate on a stock moving lower, they can buy put-option contracts. To do that, they pay the entrance fee (the premium) to the put-option seller – you!
People Really Pay For Those Things?
This is when I typically get that question.
Exactly! Who in their right mind thinks WMT is going to fall to $47.50 in the next 10 months?
My reply - Who cares!
Whoever they are, they’re willing to pay you $15 for every 100 shares of WMT you commit to buy at $47.50 per.
If you sold 10 contracts, you’re committed to buy 1,000 shares.
The contract is in effect until January 17, 2020.
Now, obviously you can’t buy WMT today at $47.50 because it’s still trading at $97.59 per share.
So, for you to buy the shares at $47.50, WMT would actually have to fall to that level in the next 10 months.
If it doesn’t, you just walk away with your $15.
If it does, then you follow through and buy your 100 shares and pay the $4,750 cost. The money would be deducted from your brokerage account just like any other typical stock purchase would.
But seriously, why would someone buy that put option when it seems like a certain loser?
Speculators & Hedgers
Two reasons why:
1. Someone is outright speculating, and quite honestly, thinks WMT will really fall that far in the next 10 months.
This is my favorite kind of player. Not because I want to emulate them, but because they’re the easiest ones to make money from, and they’ve helped line my pockets for years.
2. Someone is hedging a prior purchase of WMT shares they made and wants to set a floor price for their stop-loss point. In this case, they’re looking to sell their shares at $47.50 if it drops that far.
Who knows, maybe they were lucky enough to buy WMT for $10 per share many years ago, and now they want to protect those gains.
The Odds Are In Our Favor
Here’s the reason why I love the speculators, and why I’ve made tons of money from them.
According to my favorite “secret weapon” above, the chances of WMT falling to $47.50 in the next 10 months is basically zero.
Said another way, the chances of WMT staying anywhere above $47.50 in that time frame is a 99.91% probability.
As long as WMT stays above $47.50 per share, the put-option buyer will lose their bet of $15 per contract.
The put-option seller! They’re the ones who collect on these bets that typically have over a 90% chance of winning.
For years and years, I’ve been selling put-option trades like these and putting high odds of success in my favor.
And the thing that excites me most is that anyone can do it.
But there’s something more subtle underlying this type of trade.
You can actually use it to attempt to purchase a stock of your choosing at a price of your choosing – just like Buffett did with Coca-Cola.
Now, we all know the chances of WMT falling to $47.50 over the next 10 months is practically nil.
But what if you had interest in buying WMT at say $75 per share, or even $80 per share?
Those levels might be more attainable, especially if we have a bear market move in that time frame.
That could be great levels to get your hands on some shares if it meets your risk parameters.
And just for information sake (looking back at the option chain above), the January 2020 $75 puts are paying out $126 per contract and the January 2020 $80 puts are paying out $189 per contract.
I write about selling put options all the time, and it's the main topic of this blog.
It's also the way we make money in our Smart Option Seller newsletter.
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I hope this blog entry was informative, and if you are reading it, most likely you have already received a free copy of my "Put-Selling Basics" e-book which explains the strategy in greater detail.
Hope to have you onboard.