Writing deep in the money puts with very short term contracts is a strategy to create an entry point at a price discounted from the prevailing retail market price.
This simple technique is easy to learn and can be applied to buying any stock that also has options traded.
The technique discussed is one part of my Engineered Income Investing tool box. More use covered option writing to boost cash income and yield while reducing market risk.
Here, I present a discussion of the retail reduction technique and provide a real world example for current use to create a buy on AMGN shares.
Author’s note: Members of Engineered Income Investing received early access to this material – and exclusive early access to all of my top investing ideas.
Nobody likes to pay retail. A trip to the wholesale district is always a welcome shopping venture. You can also buy your stocks at a discount to retail if you know the techniques. Stop paying retail. Use the Engineered Income Investing technique that I discuss here to enter your stock positions at prices discounted from what most people are paying.
A reader recently wrote to me to say he wanted to open a position long in AMGN shares. Because he is familiar with my use of covered option writing to improve results while lowering (but never fully eliminating) market risk, he asked if I had any thoughts I could share on the best way to do this for buying in to Amgen Inc. (AMGN).
Below, I share my reply with him. I walk through the use of writing (selling short to open) very short term put contracts for AMGN that are deep in the money. The short term and deep in the money are both targeted to make it highly probably shares will be presented through the put contracts. So long as the market share price remains above the strike price of the put that is written until the expiration date of the contracts, the shares will be sold to the put writer at the contract strike price.
When writing puts (selling to open), the strike price minus the option premium price is the net price the writer will pay for presented shares (plus some nominal commissions). For example, if I write a contract expiring in 4 days for the AMGN $180.00 strike @ $5.20 premium, the net basis price I will have for my entry point if shares are presented and sold to me is the $180.00 minus the $5.20 premium = $174.80.
The alternative is to buy shares on the open market today, paying the $175.28 price they are trading at. So, the use of writing the put contracts now is my highly probably entry at $0.48/share below the market price I would pay doing an simple conventional retail buy now.
In addtion to the discount entry basis cost from retail, the market risk is reduced for me when I use the put option strategy rather than the retail market buy of shares. If the shares rise above $180.00 in the next 4 days, I will not end up owning them. Instead, I will have made a $5.20 return on my net covering cash of $174.80 per share. This is an absolute gain of 2.97% (271.54% annualized yield rate that I would get if I could keep repeating similar trades on AMGN or any group of tickers to keep my covering cash tied up at the same rate over an entire year).
So, how has my risk of a market move to the upside been modified in relation to a simple retail buy at market price? That depends on the size of the move. My maximum profit of a market move to the upside above $180 in the next 4 days is the $5.20/share. Even if the shares rise further, I will not make a larger gain on this opportunity. On the other hand, the retail share buyer would need shares to move up from the current market of $175.28 to $180.48 in order to make the same gain as I get on the quick short-term rise. A $0.48/share cent advantage for me on shares up to that point. Furthermore, note that the retail buyer paid (and tied up) $175.28 cash investment, while I tied up only $174.80 net covering cash investment. So, I get a $0.48 advantage on the investment net cost and another $0.48 on the short term rise to $180.00. A $0.98/share advantage is no small thing. Especially if you are dealing in large trades of many 100s of shares.
If shares should fall in price, my option premium aided basis…