Options are a tool to complement your stocks and they give you more ways to generate returns than from stocks alone. At Journey with Money, one of our favourite strategy is selling put options. When you sell a put option, you are agreeing to buy the underlying stock (a stock you choose) at a set price (the strike price) by the option’s expiration date. You are basically selling insurance into the market that says, ” If the stock falls to this strike price or lower by the option’s expiration date, I will buy the stock at the strike price.” When you sell this insurance into the market, you get paid the option premium in cash. This is a popular way to generate healthy, recurring income while also targeting a lower potential buy price on a stock you want to buy if it falls.
One of the greatest investor of all time, Warren Buffett used this same exact strategy to gradually build his Coca-Cola stock position, getting paid income at the same time. He also did this with other stocks he targeted over the years too. When you are able to combine your value investing knowledge together with options, you will be able to enhance your returns and compound your wealth at a very much faster rate.
Recently, we have been sharing about Alibaba. So let’s use Alibaba as an example for us show you how you are able to collect option premium for Alibaba. In value investing, we are always on the lookout to find companies with wide and deep economic moats that will give them strong revenue growth that is sustainable and we want to buy them as best as possible below their intrinsic value.
Using our discounted earnings model, with discount rate at 10.5%, 1st 10 year growth rate at 20% and next 10th year growth rate[terminal] at 10%, I get an intrinsic value of $180 for Alibaba. So if I will buy the stock at $160 (current price of Alibaba at the point of writing is around $175), I will get a margin of safety of around 12%. As an value investor, I will always want a better margin of safety for myself. 10-15% for a business like Alibaba is something which I am comfortable with. Since I am not able to buy Alibaba at my target price of $160 currently, I will then proceed to the options market to see if I can sell any put options to generate cashflow for myself while waiting.
As you can see from the screenshot capture above on TD Ameritrade platform, by selling 1 put option contract of Alibaba with strike price $160, I was able to collect a premium of USD 365 upfront. Do note that that 1 option contract means you have to buy 100 shares. To initiate this position, I must have already set aside capital of USD 16,000 to buy 100 shares of Alibaba shares when required. So if the share price of Alibaba will to stay above $160 on 20th Sep, nothing will happen. Perfect, I get to keep my USD 365. But if the share of Alibaba will to drop below $160, I will then need to buy 100 shares at $160. Isn’t this also wonderful? You are getting paid while waiting to buy the stock at the price you wanted anyway. If you would like to find out more about how we use this strategy in greater detail, we will be conducting our Stock Investing Masterclass workshops in September and October. These will be our last 2 workshops for the year so do come and join us to find out more. Click here.
At our workshops, we are also looking to share how you are able to position yourself in the current economic climate.
At Journey With Money, we are practitioners of Value Investing for Singapore and US stocks. We are passionate about sharing our Stock Investment knowledge and experience but the materials we present do not constitute stock recommendations and readers are urged to do their own due diligence for any investment decisions.
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