Let’s say XYZ company stocks have recently fallen dramatically to around $17 on high volume – sometimes referred to as ‘capitulation volume’.
The stock has since been trading in a range around this ‘bottom’ area and you believe that it can’t fall much further. This makes it a good buy and you would be happy to own the shares if they fall as far as the $15 price level.
You also have sufficient capital to purchase 500 shares.
This is what you do:
- Sell 5 put option contracts at a strike price of $15 with an expiration date about a month away, and
- Purchase another 5 put option contracts at a lower strike price, same expiration date.
This is called a put credit spread, otherwise known as a “bull put spread“. You need the ‘long’ position as a kind of insurance protection in case the stock plummets further. You will receive a net credit to your brokerage account.
Once this is done, three scenarios can follow:
1. The stock stays around the $17 level by the options expiration date. In this case, you get to keep the credit you have received and can choose to write another put credit spread for the following month. You have effectively been paid for waiting for the stock to reach your desired level.
2. The stock falls to $15 and you are exercised on your sold options and the stock is put to you. You now own 500 shares of XYZ and can then implement further strategies using options, such as selling covered calls with protected puts.
3. The stock plummets to way below $15. In this case, the stock will be assigned to you, but your bought puts will increase in value and limit your potential losses. You could use the profit from these bought puts to buy more shares and in doing so, average down your entry price as part of a longer-term wealth-building plan.