Most investors are familiar with dollar–cost averaging as a wealth building strategy. It involves investing a fixed amount of money at regular intervals over a long period of time. This type of systematic investment program is commonly used in company sponsored pension plans.
I use a similar approach by selling call & put options to build a stock portfolio. At first glance it sounds really complicated, but the math is simple as long as you can subtract and divide.
The two types of options: calls and puts (Investopedia)
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.
My strategy involves selling options and collecting a premium which will hopefully reduce the cost of buying a stock. For example: I recently wanted to add 200 shares of Royal Caribbean Cruises (RCL) to my stock portfolio.
Here is the math: I bought 100 shares at $72.22 on Oct 11th
Sold 1 call option Nov $72.50 for $3.40
Sold 1 put option Nov $72.50 for $3.65
Now both these options expire on Nov 18th, so the buyer of the call option can force me to sell my 100 shares for $72.50 and the buyer of the put option can force me to buy 100 more shares at $72.50 depending upon the share price on Nov 18th.
Scenario (1): What happens if the shares of Royal Caribbean are trading below $72.50 on Nov 18th?
The call option expires worthless and I will buy 100 shares that will cost me $72.50 – $3.40 (the call premium) – $3.65 (the put premium) for a total share cost of $64.45. If you add the cost of the 100 shares that I bought for $72.22 to the 100 shares for $64.65 and divide be 2, my dollar cost average per share is $68.84
Scenario (2): What happens if the shares of Royal Caribbean are trading above $72.50 on Nov 18th?
The put option expires worthless and I have to sell my 100 shares for $72.50 but the cost of my 100 shares that I bought for 72.22 have been reduce to $65.17 ( $72.22 – $3.40 call premium – $3.65 put premium), my net profit on the trade would $7.33 divide by $65.17 or 11.2 % in just 38 days. (Excluding trading commissions)
In order to use this strategy, you need to have a margin account with a discount broker and be approved for cash secured put option trading. The added bonus of this strategy is you can use it to buy most index funds and some EFTs, you don’t have to buy individual stocks. However, the option premiums on index funds & ETFs will be much lower because they are less volatile than individual stocks.
I like this strategy because it removes some of the emotion out of investing. In the past, I would take half a position in a stock but I found it hard to commit to buying the other half when the share price fell. Plus I would kick myself for not taking a full position when the share priced increased in value. I found averaging down or up was very difficult. In reality the decision of buying or selling is sold to the purchasers of the options for a fee. An additional benefit, option premiums are taxed as capital gains, as long as you are not making a living as a day trader.
Stay tune; I will post the results of this trade next month plus an additional trade based on which scenario unfolds.
Disclaimer: This post is for educational proposes and not an investment recommendation.