It looks like a great time to buy stocks.
Major indexes have suffered the first stock correction since 2011. Your favorite stocks such as Coca-Cola, Apple, Walt Disney and General Electric are trading at bargains. And during this extended bull run, buying on a correction or dip has paid handsomely. Some even believe today will provide the same results.
But, stocks can fall farther … much farther.
At the moment, stocks — as measured by the Dow Jones Industrial Average — are broadly down just over 10% from their 2015 highs.
But, during the 2008 financial crisis, equities fell more than 50% in less than two years — meaning they could fall another 40% before a bottom is in place.
So how do you attempt to buy stocks knowing that a bottom may not have been made yet? It’s easy — sell put options.
Let me explain…
This strategy allows you to jump in, without technically jumping in.
It works this way because you don’t own the stock when making the trade. Instead, you have an obligation to purchase shares at a price you choose if the shares fall below that price within a set time frame.
By agreeing to these terms, you get paid, instantly collecting hundreds or thousands of dollars, depending on how many stocks you would typically purchase. And you also build a cushion to limit losses.
This is a strategy I have perfected in Pure Income to generate double-digit returns consistently.
And the market today makes it an even more lucrative strategy because of one simple factor — the VIX.
Grabbing Up Higher Gains
The CBOE Volatility Index (VIX), also known as the fear index, is an indicator that depicts how much investors are willing to pay for protection.
When the VIX is high, generally above 20, that means investors are coughing up more cash to buy put options as a form of protection. When it’s low, less than 20, it means premiums on options are relatively cheap — which is a great time to buy.
Today, the VIX is sitting above 25, more than 80% higher than where it was one month ago. This tells us that the wild market swing sent investors rushing for protection, driving the price of options higher.
For option buyers, it means you’re potentially overpaying for protection.
For put sellers, this means you’re collecting more income.
It’s why today is an ideal opportunity to sell put options. This is also why I recommended selling puts on a global pharmaceutical company in Pure Income just the other week.
But, even if your goal isn’t to just collect the income from selling the options, this strategy works great to buy stocks at a lower price.
Adding a Cushion of Protection
As I mentioned, when you sell put options, you have the obligation to purchase the shares at the option strike price. In making this agreement, you collect instant money. So what’s the risk?
The risk is if the stock price falls below our strike price.
In that scenario, you must buy the shares at the strike price, regardless of the current market price — even if it drops to $0 you still pay the strike price per share you originally agreed to. That’s why it’s important to sell put options only on equities that you want to own.
But, the risk is no different than owning the stock outright. One big difference is that you are building a cushion when you sell put options — that is the difference between your entry costs compared to where the stock is trading today.
For example, let’s say General Electric, a leading industrial company, is trading at a great bargain and is one you have been interested in for a while. It is currently trading at a forward price-to-earnings multiple of 16, expected to grow revenues slightly with earnings growing at 17% a year. The stock currently yields 3.7% and it looks like a great opportunity to purchase shares.
But, after shares tumbled 12% since peaking in April of this year, the selling may not be done yet.
The stock is currently trading at $25.
Instead of purchasing shares at today’s price, you can sell put options at a lower strike. The December $23 put option is trading at $0.70, which helps build your cushion.
Combining the difference in the strike price and current price ($25 minus $23) with the premium we receive for selling the option ($0.70) means we are adding a cushion of $2.70.
In other words, the shares of General Electric can fall another 10.8% before your return is negative. So, if you end up having to purchase shares at $23, you are far better off than had you purchased them today.
If you are put a stock, then you can hold onto that position, possibly sell covered calls to generate even more income and benefit from the coming rebound.
Then, if you end up purchasing shares at the strike price, you are way better off than had you purchased them on the day you sold the put — nearly 15% better. Then you just hold onto your stock, possibly sell covered calls to generate more income, and benefit from the coming rebound.
And if shares fail to drop to the strike price in the specified time frame, you get to keep the premium you collected for selling the option and then you can sell another put option.
While the current market environment is challenging for many portfolios, selling put options is an ideal way to benefit from the volatility, while still having the benefits of a buy-the-dip opportunity.
Editor, Pure Income