When long term investors want to invest in a stock, they usually buy the stock at the current market price, and pay the full price for the stock. This method of buying stock has no advantages, and is the standard stock buying strategy that is used by the non trading public.
A better way to buy stock for a long term investment is to use stock options. By using the correct stock options strategy, long term investors can have control over the price at which they buy the stock, and also buy the stock at a lower price than other investors.
Stock options are options which are based upon a single underlying stock (such as GOOG for Google). Stock options can be used to trade a stock for the short term, or invest in a stock for the long term. Stock options are available on most individual stocks in the US, Europe, and Asia, and are usually traded using one stock options contract for every 100 shares of the underlying stock.
Further information about stock options, including a description of stock options contracts, is available in the stock options article.
Buying Stock Using Stock Options
When using stock options to invest in a particular stock, the reasons for investing in the stock should be the same as when buying the actual stock. The only difference is that the stock purchase is executed using options contracts instead of the underlying stock. Once a suitable stock has been chosen, the stock investing trade is executed as follows:
- Sell one out of the money put option for every 100 shares of stock
- Wait for the stock price to decrease to the put options' strike price
- If the options are assigned (by the exchange), buy the underlying stock at the strike price
- If the options are not assigned, keep the premium received for the put options as profit
Advantages of Stock Options
There are three main advantages of using this stock options strategy to buy stock.
Firstly, when the put options are initially sold, the trader will immediately receive the price of the put options as profit. If the underlying stock price never decreases to the put options' strike price, the trader will not buy the stock, and will keep the profit from the put options.
Secondly, if the underlying stock price decreases to the put options' strike price, the trader will buy the stock at the strike price, rather than the previously higher market price. As the trader chooses which put options to sell, they can choose the strike price, and therefore have control over the price that they buy the stock at.
Thirdly, as the trader received the price of the put options as profit, this provides a buffer between the purchase price of the stock, and the breakeven point of the trade. This buffer means that the stock price can fluctuate slightly without causing the stock trade to go into a negative profit / loss.
A long term stock investor has decided that they want to invest in XYZ company. XYZ's stock is currently trading at $430, and the next options expiration is one month away. The investor wants to purchase 1,000 shares of XYZ, so they execute the following stock options trade:
Sell 10 put options (each options contract is worth 100 shares), with a strike price of $420, at a price of $7 per options contract. The total amount received for this trade is $7,000 (calculated at $7 x 100 x 10 = $7,000). The investor receives the $7,000 immediately, and keeps this as profit.
Wait for XYZ's stock price to decrease to the put options' strike price of $420. If the stock price decreases to $420, the put options will be exercised, and the put options may be assigned by the exchange. If the put options are assigned, the investor will purchase XYZ's stock at $420 per share (the strike price that they originally chose).
If the investor does buy the underlying stock, the $7,000 received for the put options will create a buffer against the stock investment becoming a loss. The buffer will be $7 per share (calculated as $7,000 / 1000 = $7). This means that the stock price could continue decreasing to $413, before the stock investment goes into a negative profit / loss.
If XYZ's stock price does not decrease to the put options' strike price of $420, the put options will not be exercised, so the investor will not buy the underlying stock. Instead, the investor will keep the $7,000 received for the put options as profit.
If you are considering investing in a stock for the long term, think about using stock options instead of buying the underlying stock directly. Using stock options in this manner, can considerably reduce the risk and potential loss of long term investing in stock. This can significantly increase your risk to reward ratio, and thereby your profitability.