In last week’s column, I sounded a little pessimistic — saying that most investments look relatively expensive while the overall risk of a fall is far greater than most people seem to believe.
That type of commentary always prompts some readers to wonder if they should simply run for the hills and wait things out.
My answer? No.
First off, if you happen to own quality investments and they’re part of a long-term plan, there’s no need to do anything at all … especially if you are earning steady income just for holding them.
And even if you have cash on the sidelines right now, you don’t have to sit around doing nothing.
You can actually get paid to try and buy your favorite stocks at lower-than-current prices.
The process is called cash-secured put writing and it’s one of the two core strategies we use in my premium Superstar Trader service.
Now, yes, the strategy revolves around options — the class of investments Warren Buffett famously called “financial weapons of mass destruction.”
Yes, when you speculate with options you can (quickly) lose all of the money you put at risk.
And yes, using options inherently involves a bit more complication than simply buying stocks or ETFs.
At the same time, cash-secured put writing:
Has actually been used by Warren Buffett to generate several billion dollars in upfront money.
When used correctly, can actually LOWER a portfolio’s overall risk.
And is not very hard to use at all, once you understand how it works.
First, let’s summarize what put selling is all about.
Put options give someone the right to sell a certain stock … at a certain price … over a certain period of time.
Investors typically use put options to protect themselves against future price drops or as a way to speculate on the very same price drops.
So, essentially, selling put options is selling insurance to other investors. And you get to control ALL the variables — the particular investment being covered by this insurance, how long the insurance contract is good for, and even how much you’ll accept to issue the “policy.”
Here a few things you need to know:
A. One options contract covers a “round lot” of the underlying investment — which means 100 shares.
B. Options on U.S.-listed contracts expire on the third Friday of a given month, unless that Friday is a market holiday. In the latter case, they expire on the preceding Thursday.
C. To buy or sell options contracts, you will need to get clearance from your brokerage. However, writing options requires the most basic level of clearance, and you should simply need to fill out a quick form.
I primarily recommend writing puts as a way to collect upfront income and target high-quality investments you’d want to own anyway …
Let’s say you like XYZ dividend stock that’s currently trading at $16 but you’d like to buy on a dip, when it hits $15.
Well, instead of just waiting around for a pullback — which is what almost all other investors do — you can sell a put option instead.
In this case, you’d be selling someone else the right to sell you 100 shares of their XYZ at $15. And again, you could determine how long this right was good for — maybe a contract length of two months or so.
Once you’ve sorted out those details, you just place this order with your broker like you do any other trade. It really is just as easy, in fact.
Then, after someone agrees to buy this insurance from you, you’ll immediately collect your premium — the money they paid to buy the insurance from you.
It could amount to hundreds or even thousands of dollars, depending on a number of factors.
That cash is yours to keep no matter what happens next. So immediately, you’ve already made some money!
And in all but one scenario you end up keeping that money with no other obligation.
Better yet, you’re free to do whatever you want next — including writing ANOTHER contract and collecting MORE cash upfront!
What about that other scenario — the one where you don’t just keep your insurance premium and move on?
Well, let’s stick with our example and say XYZ goes down to $15 (or below) and the other person decides to actually use the insurance.
That last part is a critical distinction because, only one out of 10 people end up actually using their insurance.
Anyway, in this case, you will have to buy the shares of XYZ at $15 like you agreed to do.
Please note that this is the only price you can be asked to pay — never a penny more or less.
And as long as you have the money in your brokerage account to pay for the shares — which is always what I recommend — then you’ve actually still essentially “won” with this strategy.
The reason is pretty obvious: You ended up owning an investment you wanted to buy at the price you wanted to pay.
More than that, you actually bought it at a LOWER price than you wanted to pay since you also collected that premium upfront.
The only key here is that you must be ready to take ownership of the underlying stock, too!
There are just a few other things to note:
First, you could start off with an immediate paper loss when you take possession of your shares if they’ve fallen below the strike price of the contract you wrote.
Second, those losses could be substantial if the price implodes.
Third, as I mentioned earlier, you should have enough cash in your brokerage account to cover the potential stock purchase under the put contract.
It IS possible to write puts on margin — meaning you DO NOT have enough cash to cover the trade. But I don’t recommend going that route because it could result in losing other positions in your brokerage account … and/or owing money that you don’t actually have in the event that your put contract is exercised.
The bottom line is that once you get comfortable writing put options, it’s quite likely you’ll never end up just waiting for a pullback or entering limit orders on investments you want to buy.
Instead, you’ll happily start getting paid to wait — which is the very cornerstone of smart income investing and a smart way to deal with the kind of market we have right now.