Investors holding stocks or buying and selling stocks are familiar with “market” and “limit” orders. In placing a market order, they either buy or sell the target stock at the current market price when the order hits the trading floor. In placing a limit order, they are offering to sell or buy a stock at a specified price or “better”, better meaning lower than the specified price if they are buying or higher if they are selling.
Particularly for those who are frequently placing limit orders to buy or sell stocks, there is another approach that can accomplish the purchase or sale, but the investor receives or pays a better net price. This is accomplished through the sale of a call option to sell stock or the sale of a put option to buy a stock. Here is how each strategy works. All options are traded as representing 100 shares of the underlying stock. So, 1 call or 1 put option represents 100 shares of the stock.
Using a call option to sell a stock that is owned:
Suppose the investor holds 200 shares of stock XYZ currently trading at $50/share. This investor could place a limit order to sell at $60 that is GTC, Good Till Canceled. That order will sit there until the stock reaches $60/share, and it automatically executes or it could be canceled at any time. The investor may be willing to wait months for the execution, but that is fine with them as their target selling price is $60.
Another approach is to sell 2 call options with a strike price of $60/share. In this example, the investor sells the call options with an expiration out 90 days for $1. This means that the holder of the stock will receive $1/share or $200 as the option premium. This is non-refundable money, no matter where the stock price goes. The three possible outcomes are:
1. The stock sits still or trades in a tight range. The holder of the stock who sold the option keeps the $200 premium and the option expires without forcing the sale. This is the same result as the limit order, as the stock does not sell, but the holder of the stock is now $200 richer.
2. The stock drops in price. The holder of the stock has intended to hold for the long term and expects these dips, so they are not necessarily alarmed and would not sell in this situation anyway. They sold the call as above and collected the $200 premium. The result is that the stock is down in price, something they would have experienced anyway, but they can keep the $200, offsetting their paper loss by $1/share (commissions excluded).
3. The stock rises to or above $60/share before option expiration. The option buyer will force the sale of the stock at $60/share, the same result as the limit order. The holder of the stock ends up selling, but at a price $1 higher than their limit order due to the premium they received (commissions excluded).
The investor holding stocks they would sell at specified prices can just let limit orders sit, but using call options they can be taking in premiums along the way until the stock does sell at their chosen price. Also, over time they can adjust their price upward with a slow rising stock, enjoying even higher returns.
Using a put option to buy a stock at a specified price
Another way in which investors place limit orders for specified prices is to buy stocks at prices lower than the current market price. Using the call option XYZ stock trading at $50/share as an example, the investor wants to buy it, but only at $40 or lower per share. They can place a GTC limit order to buy at $40 and just wait.
The other option is to sell “naked puts”. While investors hear horror stories about the naked put strategy, they are about investors who sell them behind rising stocks hoping to just keep the premiums while the options expire. If the stock drops to or below the strike price of $40, they are forced to buy it, and they may experience a margin call for cash to do so.
In this example, the investor wants to own the stock, but only at $40 or lower per share. They have the cash or margin in their account to buy it, just as if they placed a limit order. However, in this case, they get the premium for selling the 2 put options for those 200 shares they want to buy. If that put option sells for $0.75/share, they take in $150 in premium and wait until expiration of the option, with three possible outcomes:
1. The stock trades in a tight range above $40 until expiration. The option seller keeps the premium and can repeat the process to take in more premium while they wait to buy at their desired price.
2. The stock rises in price. This is the same situation as if they had placed a limit order to buy. They do not get a chance to buy the stock at their desired $40/share, but if they sold the naked put, they would have the $150 premium in their account while waiting until expiration. At expiration, they can repeat the process.
3. The stock drops to or below $40/share. This situation would result in the put option seller being “put” the stock, meaning buying it at $40/share. This is the same result as if they had used a limit order, but they really ended up buying at a net $39.25/share considering the collected premium (commissions excluded).
As with the call option for selling example, the investors who use options for buying instead of the limit order will be able to keep selling puts for premium until they get their desired stock purchase price. Active investors who buy and sell stocks with limit orders may find that using options as their trading tools can increase their return on investment while achieving the same stock transaction results.