Disclaimer: option trading can be conservative or risky – it pays to take some time and educate yourself. A great start would be to check out Mark Wolfinger’s “The Rookie’s Guide to Options” before getting started with option trading.
Have you ever had your eye on a stock and thought to yourself, “I’d like to buy it if it becomes cheaper”? Some people may decide to enter in a limit order to buy the stock for 5% or 10% below what it is currently trading at. For example, stock XYZ is trading at $50/share and you would like to buy 100 shares for $45/share. You could just enter in an order to purchase 100 shares with a limit order of $45/share. If the stock never dips down to $45/share, your order goes unfilled and you aren’t out any money. But if it does go down to $45 (or lower) then your order gets executed. Many people put in “stink” bids on stocks all the time, knowing full well their orders may never get executed and some may get filled at what they perceive to be great bargains.
An Alternative: Writing a Put
Another way of accomplishing essentially the same thing (and perhaps with an advantage) is to write a put option on that stock with a strike price of $45/share. A “put option” is a contract that gives the holder the right to sell a stock for the strike price indicated for as long as the contract is in force (the “term”). These contracts have value, and by “writing” a put contract you are SELLING someone else this contract. This contract holder will have the right to sell their stock and you must agree to purchase it at the strike price.
So let’s go back to our example. Stock XYZ is trading at $50/share and you would love to be able to buy it for $45/share. Instead of placing a stink bid for $45/share, you sell someone a put option on the stock with a strike price of $45/share (1 contract is for 100 shares) and a term of 6 months. You sell this contract for $1.50/share (or $150 total for one contract). No matter what happens, this $150 is yours to keep. If in the next 6 months, stock XYZ never makes it down to $45/share the option holder won’t have any reason to force a sale of XYZ to you at $45 and the contract will expire worthless. If you still wanted to potentially buy it for $45/share, you could just turn around and sell another contract and collect the premium again.
If XYZ does make it down to $45/share (or lower), then the option holder may exercise their option to sell the stock to you at $45/share. So what has happened? The stock that you were willing to purchase for $45/share is yours for $45/share plus you pocketed $1.50 share extra. So really the cost is more like $43.50/share.
If XYZ completely takes off, you would miss out on the potential gains if it never made it down to $45/share.
If XYZ drops like a stone quickly, you could be forced to buy it for $45/share when it could’ve gone down as low as $35/share (but if you had a stink bid in, it would’ve been subject to the same problem).
What’s been described definitely is riskier if you don’t have the cash in your account to buy the shares if the stock is “put to you”. Having the cash makes this “writing a cash-secured naked put”. Naked means you don’t have an offsetting short position in this stock at the time of writing the put. This is dangerous when you don’t have the cash to make the purchase (although many discount brokerages don’t allow writing of puts if you don’t have the cash to secure it in the account).
Having said that, for people who are used to placing limit orders for securities at a significant discount to the market price, you may well want to look more into writing a put instead. It’s not unheard of for people to continuously write puts against a stock, not have the stock get put to them, and just pocketing the premiums over and over.