Bargain-Hunting With Options

One creative way in which put options can be used is to buy a desired stock at a discounted price. 

This strategy works best when a stock has recently had a sharp drop, to a point that you believe is a bargain price. It will allow you to buy the stock at a discount from the current market, if the stock behaves as you expect. And if the stock suddenly soars, you may make a tidy profit even though you missed buying the stock. Here’s how it works.

When stocks drop sharply, some of the people who hold them buy put options as protection. From their point of view, they are buying a guaranteed stop-loss. This increased demand for puts drives up their price.

A savvy investor can then sell put options on the stock in such a way that the only possible outcomes are

  1. Purchase of the stock at a significant discount to the present market price or
  2. A high return on the cash that is committed to the potential stock purchase.

Example Put Option Trade 

*Example only, not a trade recommendation*

Early in December, the stock of Vodafone (VOD) seemed to be reversing its months-long slide. Financial press were reporting that new management had frozen the dividend at current levels in order to reduce debt, with plans to resume increasing it when this was accomplished. The market had responded positively.

Even though frozen currently, the dividend yield was still quite attractive at well over 8%. The stock had broken out of a long-term downward channel as shown here:

(Click on image to enlarge)

Graph showing VOD downtrend in the stock market

In the first week of December a selloff gripped the markets and VOD was knocked down by about 5%, in line with the indexes, as shown here:

(Click on image to enlarge)

Stock chart showing VOD recovery and subsequent drop in price.

If you believed that VOD, with its good dividend yield and substantial positive free cash flow, was a good long-term investment, then here was an opportunity to buy it at an attractive price.

With the stock at $20.72, 500 shares would cost just a little over $10,000 ($10,360 to be exact).

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Alexis Renault 3 hours ago Member's comment

Do you have any courses on options?