When It’s Good to Be Worthless

One of the worst things that can happen to you as an investor? One of your stocks drops down to zero.

Naturally, most investors bail out of a stock long before that happens. So unless bankruptcy comes out of nowhere, odds are you won’t suffer this experience.

However, there are times when you want your investments to be worthless. That is, of course, after you’ve already gotten paid.

That’s where stock options come into play. They leverage momentum, one of the most powerful investment tools around.

Options can be a lot to wrap your head around.

In my first job after college, my new boss handed me a well-thumbed copy of Barron’s Dictionary of Finance and Investment Terms.

While eagerly flipping through it, I soon landed on the section about options.

I’ll admit that I just didn’t get it the first time around.

Then, I read it again and still didn’t get it. After three or four perusals, I finally achieved a rudimentary level of understanding.

A Few Basics

Don’t worry: I won’t bore you with all the ins and outs of options.

But there are a few things you need to know.

Options are contracts that let you buy or sell 100 shares of stock per contract at a specific price by a certain date.

Call options let you buy a stock at an agreed-upon price by a particular date. Put options let you sell a stock at an agreed-upon price by a particular date.

Bullish investors buy call options when they expect the price of a stock to jump higher.

Bearish investors buy put options when they expect a stock to drop.

And investors of all stripes buy put options as a sort of insurance policy on a stock they may be worried about.

Why Buy When You Can Sell

Now, here’s where things may get a little confusing.

There’s a lot more you can do with options than simply buying them. For instance, you can also sell them.

Now, selling shares of stock you don’t already own—also known as shorting—can be incredibly risky.

Short sellers are betting that the price of a stock will soon fall sharply.

The problem is the stock market goes up about two-thirds of the time. That gives even shaky stocks crucial support.

And if there’s unexpected good news, there’s no telling how high an individual stock can rise. That means a short seller’s potential loss is theoretically infinite.

But selling options you don’t already own is very different from doing the same thing with stocks.

In fact, many conservative income investors sell options to generate income without the risk of holding the actual stock.

One way to do this is by selling a put option that expires in three months or less. When you sell a put option you collect cash up front from the sale. And it’s yours to keep.

Remember earlier when I said buying a put allows you to sell a stock at a particular price by a certain date? Well, selling a put does the opposite.

Selling a put obligates you to buy 100 shares of stock in the future at an agreed-upon price (i.e., the strike price) if the put expires in the money—meaning the stock trades at or below the strike price upon expiration.

If the stock trades above the strike price at expiration, then the put you sold expires worthless. That may sound bad, but it’s exactly what you want to happen in this scenario.

After all, it means you got paid without the risk and responsibility of owning the actual stock.

How to Get to Zero

To reduce the possibility of having to actually buy the stock at expiration, put sellers look for contracts with strike prices at a significant discount to the current market price.

Naturally, it also helps if the underlying stock is fundamentally solid, and its share price is generally trending higher.

As an example, if XYZ stock trades at $45 per share, you might look to sell a put with a strike price of $40 that expires in three months or less. The $40 strike gives you an 11% buffer.

Again, in this scenario, most put sellers want the option to expire worthless. So that buffer is important.

If your trade works out as planned, it’s sort of like creating your own dividend out of thin air … without the risk of stock ownership.

The best part about this strategy is that you no longer have to wait around for a company to pay a dividend. You can get paid whenever you want.

Of course, you also need to have the cash necessary to buy the stock in case the put you sold expires in the money and the stock gets put to you.

But there are other ways to mitigate that risk—my colleague, Jim Fink, is an expert in that arena. And he loves to turn newbies into experts as well.

At the same time, there are also ways to create more instant dividends if the stock does get put to you. So having to buy the stock in this scenario doesn’t have to be a bad thing.

Nevertheless, life is easier when the put you sold expires worthless. And that’s one of the only times when income investors want to see a total wipe-out.