How to Earn Money While Waiting for a Pullback
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There is a typical tradeoff between buying a promising stock now and waiting for a pullback in order to get a lower valuation and a better entry point. Is it better to be patient and wait for lower prices or simply buying the shares as soon as possible is the best idea?
Most investors have had the awful experience of buying too soon and missing a better entry point a few days later, and seeing a stock you intend to buy going regularly up without pause is no walk in the park either. Too little patience can hurt you returns if you buy too soon, and too much of it can mean having to pay higher prices if the shares keep rising. Unfortunately, there is no way of knowing which of the two approaches will work better in any particular scenario.
But there are some strategies with options which help at earning some money while the investor waits for a pullback and a lower entry price, this can certainly decrease the pain of the wait in case the stock keeps going up without much of a pause. The key is to always sell puts on stocks you want to hold with a strike price you find attractive enough to make it a convenient investment.
Let’s assume an investor who sells a put on Apple (NASDAQ: AAPL) with a strike price of $500 and expiry date in January 2013. The investor in this example would collect nearly $3,000 in premium for the transaction at current option prices, if Apple is above $500 at expiration he would realize a profit equal to that premium since the puts would expire worthless.
On the other hand, if Apple falls below $500 the investor would probably be forced to buy 100 shares of Apple at that $500, for this reason it’s very important to be absolutely sure about the merits of such transaction. According to earnings estimates Apple could easily be trading at a Price / Earnings ratio near 10 at a $500 price tag, that valuation looks really attractive for such a high quality business, so Apple could be a nice candidate for put selling.
Apple operates in a dynamic and always changing environment, so investors need to be aware of the different competitive forces which could affect the company future. Companies like Berkshire Hathaway (NYSE: BRK-B) (NYSE: BRK-A) could be considered a safer alternative for put selling since their prospects are more stable and easier to analyze.
Berkshire is a combination of high quality business with very strong competitive advantages; the company is diversified in different business areas and has a prudent financial management. There will be some uncertainties down the road linked to Buffett´s succession but it’s pretty safe to say that Berkshire is a nice candidate to buy at discounted prices.
Dividend investors could find a convenient alternative in put selling too. Consider for example the possibility of selling puts on Procter & Gamble (NYSE: PG), one of the most renowned dividend-paying companies in the world. The consumer staples business is quite stable, and Procter & Gamble has 50 leadership brands which are some of the world best known household names, within those 50 brands, 24 of them generate more than $1 billion in annual sales.
This global giant has increased dividends for 55 years in a row and is currently yielding a 3.5% in dividends, downside risks doesn’t look to high, and put selling could be a nice strategy to apply in this case. Some investors may want to combine a stock position with put selling, this would be like increasing the income received from dividends via premium collection.
The strategy can also be applied to high growth companies trading at valuations which can be considered a bit excessive. Chipotle Mexican Grill (NYSE: CMG) has been firing on all cylinders lately, this restaurant chain specialized in Mexican quick service food has reported sales growth well above the 20% mark in the last years. The company is gaining traction with its healthy food offerings and there are some nice opportunities for expansion both in the US and abroad. Chipotle could easily be one of the most interesting stories in the consumer sector during the following years.
Unfortunately, shares of Chipotle are too hot for value conscious investors, trading at a P/E ratio above 58. If you like the company but don´t like the price of the stock, selling puts may be a convenient strategy: you buy at lower prices if the shares fall and you still make a profit if they continue on their way up.
Options are not necessarily high risk instruments designed for active traders; they can also provide some very interesting possibilities for long term investors who would like to collect some premiums while they wait for an attractive entry price in fundamentally solid companies.
acardenal owns shares of Apple The Motley Fool owns shares of Apple, Berkshire Hathaway, and Chipotle Mexican Grill. Motley Fool newsletter services recommend Apple, Berkshire Hathaway, Chipotle Mexican Grill, and The Procter & Gamble Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.