Three Ways To Buy Stocks
When buying and selling stocks, most investors execute simple trades. However, there are multiple ways to trade stocks. Understanding them can lower your costs and improve your returns.
Although you may believe that trading options is risky, the strategies that I describe here are conservative. These strategies can be used to lower risks and boost returns.
But we first need a quick primer on options. An option gives the right, but not the obligation, to buy or sell shares at a defined price and on or before a defined time. You can buy or sell options.
A person who buys a call option is buying the right to purchase 100 shares of stock. The person who sells a call is creating the obligation to potentially sell them.
A person who buys a put option is buying the right to sell 100 shares. The person who sells the put is creating the obligation to potentially buy them.
Options define the price at which the trade would be executed (the strike price), the date by which the trade would occur (the expiration date), and the premium (the cost) of that option.
To trade options, you must be approved by your broker. There are several levels of option trading. Level 1 is the most conservative. That involves selling calls against positions you already own (“covered calls”). Level 2 trading allows you to sell cash-covered puts from your account.
Strategy 1: No Strings Attached
This is the simplest strategy, and the one employed by most investors. You place an order with your broker, and the order is executed.
There are several different versions of this strategy. You can place a market order, which simply executes the order at the available market price. The risk of a market order is that you don’t have any control over the price, so you aren’t necessarily getting the best price. But if you want immediate possession of the stock with no complications, this is the way to go.
An alternative is to execute a limit order. In this case, you specify the price at which you want the shares. For example, if you like a company, but would really prefer to pay 10% less, you just set the limit order, make sure you specify that it is “Good ’til Cancelled,” otherwise that trade may expire at the end of the day. Of course, the risk of this strategy is that the stock keeps moving higher and the trade is never executed.
Let’s work through examples using CVS Health (NYSE: CVS). As I write this, the current bid is $68.29 a share, and the current asking price is $68.35. So, there is very little spread between the two. If you placed a market order during trading hours and these were the prices, you know the approximate price you will pay. Specify the number of shares and execute the trade.
Let’s say instead you want to get shares at $60. One thing I always do is check to see the last time shares traded at that level. In this case, it’s been just a bit over a month since CVS was at that price and shares have been steadily rising. The choice here really depends on how badly you want the shares, or whether you are willing to be disciplined and only buy shares if they fall to that price.
I often have several limit orders open to pick up shares at “dream prices.” During the March plunge, for example, CVS shares fell all the way to $52.04. If you are patient, a crash can hand you cheap shares.
In any case, if $60 is your number, you specify the number of shares, indicate that it is a limit order, specify the price, and specify that the duration is either for that day only, or “Good ’til Cancelled.”
Note that there are some minor variations of this strategy, as there are with the strategies I describe below, but I don’t want to complicate this.
Strategy 2: Buy-Write
The second strategy requires that you are approved for Level 1 options trading. This strategy can also be executed as a market order or a limit order, as with the previous example. However, unlike the previous example, you have to trade in 100 share increments, because that is what one option represents.
In this case, you simultaneously buy shares and sell a call against those shares. Here’s what that means.
You will receive a premium for the call you sold, which lowers the effective price you paid for the shares. However, that also obligates you to sell the shares if the price at expiration is at or above your strike price. You will only use this strategy if you are willing to part with your shares at a predefined price in the future.
The upside is that you are getting shares at a discount and you are defining your profit. The downside is that if shares rise above the strike price, you don’t get any of that upside. If you believe the stock has huge upside, don’t employ this strategy. This strategy also doesn’t protect you against a falling share price. However, if the share price is below the strike price at expiration, you can repeat the process and sell another call option.
There are many different variables with this strategy. Let’s say I am willing to settle for a 15% profit for holding my shares for six months. For CVS Health, at the last price of $68.35, that means I am willing to let those shares go for $78.60. However, those options trade at certain increments (e.g., $2.50 or $5.00) and at specific expiration dates. So I will search for something in the ballpark of what I want, to see if I am satisfied with that deal.
Within Fidelity’s Options menu, I see that I can do a Buy-Write for CVS using a “Jan 15 2021 77.5 Call” and receive a premium of $2.55. That reduces the price I have to pay to $65.80, which represents a discount from the last price of 3.7%. If shares are called away on January 15, 2021 (a bit longer than my six-month time frame), my profit will be $77.50/$65.80, or 17.8%. But there will also be two dividends paid during the span for a total of $1.00 a share. That further increases the overall profit to over 19%.
Keep in mind that because of the 100 share requirement, the outlay for this trade will be $6,580 per contract.
The biggest “risk” to this trade is mental. Most people would be satisfied with the potential for a 19% profit in seven months. But if CVS shares are at $100 at that time, the investor will likely feel seller’s remorse at leaving so much profit on the table. That is honestly the hardest part of doing this kind of trade. However, if shares are below $77.50 on January 15, 2021, you can repeat the process and sell a new call against your position.
Strategy 3: Sell a Put
I sometimes describe this strategy as “conjuring money from thin air.” Recall that selling a put will obligate us to buy shares if they are below the strike price at the time of expiration.
Let’s say I really want those CVS shares at $60. What I like to do in this case is find a premium that is at least as great as the dividend I would receive for holding the shares. That means for CVS I want a $0.50 premium for an expiration that is three months out, or $1.00 for one that is six months out.
I check and see that I can sell an “Aug 21 2020 60 Put” for $1.09. That’s more than double the CVS dividend in less than three months. However, given the recent strength in CVS shares, the price is likely to be above $60 at expiration. I still get to keep the premium, but I won’t have the shares. However, I can execute the trade again. I have managed to execute trades like this repeatedly without much risk of being assigned shares. Hence, “conjuring money from thin air.”
If you want to increase your probability of acquiring shares this way, set the strike price closer to the current price. Instead of executing a limit order per Strategy 1, you sell an “Aug 21 2020 65 Put” and get paid $2.40 a share ($240 for the put). If shares are below $65, your Strategy 1 would have executed at the price, but this strategy would assign shares at $65, which actually cost you $2.40 less because of the premium you received.
Keep in mind that using this strategy means you must have enough money in your account to cover the shares if they are assigned. In this case, you need to make sure you have $6,500 in your brokerage account if you sell a $65 put.
It probably won’t surprise you to know that you can use similar strategies to sell your shares. All come with various strings attached, but these strategies can substantially lower your purchase prices and boost your returns.
While these are low-risk strategies, it is important that you are mentally prepared for the possible outcomes. With Strategy 1, you aren’t getting the best price you could get. Strategy 2 limits your upside profit, but lowers your purchase price. With Strategy 3, you aren’t ensuring that will trigger the purchase of the stock.
However, each of these “attached strings” come with benefits to you. Understanding and taking advantage of those benefits can substantially boost the size of your portfolio over time.
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