Successful investors buy low and sell high. It sounds simple, but neither task is easy to do in real time.
I am constantly singing the praises of put selling as a strategy for generating consistent income , but it can also be used to buy stocks when prices fall to bargain levels.
Buying low can be especially difficult when the market is selling off. Many investors decide to wait for even lower prices. The result is that many end up holding cash much longer than they expected.
But I know an easier way to buy low in a market that's pulling back. By selling puts when prices are high, investors are forced to buy only when a stock is cheap -- without letting emotion get in the way of a good investment decision.
Most investors have a list of great stocks they would like to own at the right price. Their watch list might include value stocks that have moved higher after years of trading at low prices or growth stocks they'd like to buy on a pullback. But oftentimes these investors lack a plan to get the stocks they want to own off their watch lists and into their portfolios.
When you find a stock you want to own, determine the price you would like to pay for the shares . If the current price is below the price you're willing to pay, the stock is a buy. But if the current price is above your buy price, selling a put using the buy price as the strike price could be the best action to take. This will allow you to buy shares at the price you want, and you will earn a return on your cash while waiting to buy.
To recap, "put" options give investors the right -- but not the obligation -- to sell a stock at a specified price before a specified date, known as the expiration date. Selling a put obligates us to purchase that stock from the put buyer if it falls below a specified price, known as the option 's strike price. When we accept that obligation, we receive cash, or what I call "Instant Income," upfront, known as a premium.
If you're an income investor, think of "Instant Income" as yields on the capital set aside to make these options trades. But the advantage of this method over traditional income investing is that I don't have to hold onto an investment for an entire year . That's allowed me to essentially collect yields of 9% every 40 days on average.
Continuing with our example, if you are obligated to buy the stock after it falls enough in price, the stock price could continue to fall. But once the put is exercised you will hold the stock in your portfolio at a price you considered to be fair, or even cheap.
In short, by determining your buy price in advance based on what you believe the stock is worth, you avoid making an emotional decision in a fast-moving market.
If the stock does not fall below the put's exercise price, you will be able to sell another option and generate more income. This will help you earn income on cash awaiting investment and ensure that you buy a stock when you think the price is right.
And once you own the stock, you can generate additional income by selling covered calls. As I've said before, the combination of these two strategies is the best way to generate income -- in any market.
With the market at all-time highs, it's especially important to have a watch list and be patient. One stock at the top of my watch list is CME Group (Nasdaq: CME ) .
CME is the parent company of the Chicago Mercantile Exchange, the Chicago Board of Trade, the New York Mercantile Exchange and other futures exchanges.
Exchanges like CME or the better-known New York Stock Exchange, operated by NYSE Euronext (NYSE: NYX ) , control the infrastructure that makes trading possible. They provide an exchange for trading to take place, ensure that quotes are distributed and process the trades. They also take steps to ensure that the traders using their services have the financial resources needed to honor their obligations.
For these services, exchanges are paid fees by traders who buy and sell. Exchanges also receive fees when they distribute price data, and they collect membership fees from their customers in addition to listing fees from companies that trade on the exchange.
If we were to compare Wall Street to Las Vegas, the exchanges are similar to the casinos. They take a small piece of a lot of action. One advantage exchanges have over casinos is that exchanges don't take losses on trades. Exchanges bring traders together and the traders buy and sell from each other. So we could think of exchanges as casinos without the risk of loss.
CME has great financials, low debt and a safe 2.3% dividend . The only problem with the stock is its valuation is a little on the high side. It currently trades at $76.67, and I'd be more comfortable buying these shares near their book value , at about $65.
To get the chance to buy shares at a price I like, or generate income while I wait, I recommend selling a put with a $65 strike price. Specifically, I recommended CME Sept $65 puts for about 65 cents. That's a put that expires on Sept 20 and pays sellers a 65 cent per-share premium, or $65 per contract (a contract is for 100 shares).
If shares of CME trade below $65 on Sept. 20, we'll be shareholders at a cost basis of $64.35 a share ($65 - $0.65). At $64.35, we'd own shares at 17 times estimated 2014 earnings and a few cents below book value. Plus, we'd lock in a 2.8% yield and be able to sell covered calls on the position to generate additional income.
If shares remain above $65 until Sept. 20, we keep the premium and make a profit of $65 on $1,300 (our "down payment" to initiate this trade). That's like getting a 5% yield in 71 days. If we can repeat a similar trade every 71 days, we'd earn the equivalent of a 26% yield in "Instant Income" every 12 months.
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