A couple of years ago I wrote an article entitled How to Create Dividends Out of Thin Air Through the Use of Stock Options. Besides being an incredibly long title, it explained how you can earn extra income on your stocks (even non-dividend paying ones) by selling call options against them.

Put Options Are Great Too

Well, it turns out that options are an incredibly versatile tool that can be used in other useful ways. Today, I’d like to discuss how to buy stocks at a discount below the current market price using the call option’s opposite twin, the put option. C’mon folks, to paraphrase the late “Queen of Mean” Leona Helmsley, only the little people pay retail! With put options, you never need to pay retail for a stock again.

Buying stock can be scary because the stock price could fall after you purchase it.  One way to reduce this risk is to sell a put option on the stock rather than purchase the stock directly. As I explained in my previous options article, a put option gives the buyer the right, but not the obligation, to sell a stock at a certain strike price. Conversely, the seller of a put option has the obligation to buy stock at the strike price if the put buyer exercises his right.  In return for assuming this obligation, the seller receives money up front. 

The beauty of selling a put is that you don’t mind getting exercised because you wanted to buy the stock in the first place. By selling the put, you are basically setting a limit order to buy the stock at a below-market price.  Unlike a limit order, however, you get paid up front and get to keep the money even if the stock never falls to your limit price (i.e., the put’s strike price). 

A Big Winner

Let’s use as an example Lululemon Athletica (NasdaqGS: LULU), the Canadian upscale retailer of women’s yoga apparel and a HUGE winner over the past three years, up more than 750%. The yoga craze has taken the U.S. by storm, with $5 billion in annual sales and 20 million followers — five times the number who were practicing the Indian import a decade ago. Morningstar calls Lululemon “one of the most compelling growth stories in the specialty apparel category” but says the stock has risen too far, too fast and is only worth $55 with a “very high” degree of valuation uncertainty.  

Selling Puts or a Limit Order, That is the Question

With Lululemon stock currently trading at $60.72, it is above Morningstar’s $55 fair value and even further above a $45 buy price that would provide an 18% margin of safety (82%*$55=$45). Without a margin of safety, I can’t buy the stock outright. Consequently, I see two choices: (1) enter a limit order at $45 and wait to see if the stock falls back to that level, or (2) sell a put option right now with a $45 strike price that expires in September for $1.70 per share. If Lululemon falls below $45 at June expiration, the put will be exercised by the owner and the seller (i.e., me) will purchase the stock at $45 per share.

But don’t forget the $1.70 per share I received for selling the put – when you take everything into account I will be buying the stock for $43.30 per share ($45.00-$1.70). Compared to buying the stock at a limit price of $45, selling the put saves me $1.70 per share which is a 3.8% savings [1-($43.30/$45.00)] off of a $45 limit order and a much higher 28.7% savings [1-($43.30/$60.72)] off of the current $60.72 price of the stock!

If you ask me, purchasing stock at a 28.7% discount to the stock’s current retail price is quite attractive.

There’s a Catch

What’s the catch and why doesn’t everyone buy stock this way?  Well, as with selling calls, your profit potential is capped at the premium you receive for selling the option. If the stock closes above the option’s strike price at expiration, your put will not be exercised, you will never own the stock, and you will not participate in any of the stock’s subsequent gain.

A 3.9% Return in Three Months? Sign Me Up!

But even if you don’t get to own the stock, there are a lot worse things than earning a 3.9% return ($1.70/$43.30) in three months’ time!

Sell $45 Put on LULU: Profit/Loss at September Options Expiration (9-22-12)

Puts Reduce Risk at Every Price Point

As the above table demonstrates, if the limit order is filled, selling the put is superior to the limit order at all prices below $46.70. That’s a nice risk reducer in case the stock declines after hitting $45 or rises only a little. If the limit order is not filled because the stock never hits $45, selling the put is superior to the limit order at all price levels.

Each option contract represents 100 share of stock, so only sell the number of put options that translates into the number of shares you would feel comfortable owning. If you would normally buy 500 shares of stock, limit your put sales to 5 contracts.

Maybe Worth a Try

If you are very bullish on a stock, simply buy the stock. If, however, you think the stock is too pricey and want to reduce the risk of owning it, selling puts as a means to buy stock at a discount below the current market price makes a lot of sense.