This is quite a powerful strategy if used correctly. In this strategy we are again selling a promise to the market. However, where in the covered call strategy we’re selling a promise to sell OUR shares, in this Insuring Shares strategy we are promising to BUY someone else’s shares if we’re asked to, on or before the pre-agreed date.
This strategy can be used for a few different purposes but one very popular use is to buy shares below market value. Let’s look at an example.
Suppose we decided we wanted to buy some shares either to hold to maybe to rent out. We’ve done our analysis, spoken to our Broker or Advisor and have selected a stock to purchase. Let’s say this stock is trading around $41.50. Now we could simply go and buy the shares at this price OR we could sell insurance on these shares.
If we sell insurance we are selling a promise that we will buy the shares for a pre-agreed price by a pre-agreed date, if we’re asked to. Let’s say we sell a promise to buy these shares for $40.00 on or before the end of next month. And for this we receive a premium of $1.75 per share. We receive this premium straight away and it goes into our trading bank.
Now if the stock price ends up at or above $40.00 by the end of next month, do you think the other party is going to want to sell their shares to us for $40.00? No they won’t because they can sell their shares on the open market for more than $40.00. Only if they shares fall below $40.00 will we be asked to buy the shares.
So if the stock prices ends up above $40.00 we do nothing and we get to keep $1.75 per share ($3,500 if we sold 2000 of them). We’ve made $3,500 for not much work.
If the stock price ends up below $40.00, we’ll have to buy the shares for $40.00. Let’s say they dropped from $41.50 down to $39.50. We’ll be asked to buy the share for $40.00 even though they are only worth $39.50. But we’ve already received $1.75 in premium, so our real buy price for the stock is $40.00 – $1.75 = $38.25.
In other words we’ve bought this stock that’s trading around $39.50 for $38.25. We’ve bought this stock at a discount. And if we aren’t asked to buy the shares, then we can do the same again the next month. Our effective buy price continually drops until we’re actually asked to buy the stock. And once we own them we can then rent them out.
Now when people hear about this strategy the immediate response is “what if the stock crashes”. Well if this happens you will still have to buy the stock at $40.00; that’s the promise we made and the reason we received the premium.
But remember, we were going to buy the shares anyway for $41.50. If we’d bought the shares and the stock crashed we would have lost the full $41.50 per share. However because we received the premium our effective buy price was $38.25 so our losses, if the stock crashed, would be less.
Sidebar: For more advanced traders there are ways to insure yourself against this. This then becomes a Credit Spread strategy, see below.
The other thing is that if the stock rises sharply after you’ve sold this insurance then, whilst we keep the premium, we won’t own the stock to enjoy the gains in stock price. So again you need to choose the stock to use this strategy with.
The option type used here is called a Put Option and because we are selling this without any protection it’s called Naked. So this strategy is called Selling Naked Puts.
This strategy is pre-programmed in Paper-Trader
