When we talk about value investing, we must mention the world class great investor Warren Buffett. The idea of value investing is basically picking up stocks with great fundamental by studying the company financial statement, understanding the company business, management, competitive advantages, growth etc. and value the company to gauge if the company is undervalue. If yes, buy it and wait for the value of the company to be unlocked to it’s fair value. When this company stock is overvalue, we sell it and move on to search for the next value stock.
Example, Apple is a great stock, the stock price is currently trading at $120 per share and after we apply valuation method (e.g. Discounted Cash Flow or Price-Earning Growth, etc), assume $112 is the intrinsic value (disclaimer: this figure is just for illustration purpose only, I do not really calculate Apple’s intrinsic value) and we are happy to buy the share at any price lower than $112 and hold it for many years, there are 2 things that we can do.
Option #1, add Apple stock to watch-list, wait for the price to hit $112 then initiate to buy Apple Stock.
Option #2, initiate a SELL PUT Apple @ Strike price $110 for 2 months DTE (Date to expiry), receive options premium, say $2. Wait until options to mature.
Scenario 1: if Apple stock hits $115 when options is matured (Options OTM)
We can initiate another SELL PUT Apple @ Strike price $110, receive options premium, say $2.5 for the next 2 months. Basically, we can continue to sell a put as long as the stock price does not hit the strike upon maturity and the stock is trading range-bounce.
Scenario 2: if Apple stock hits $106 when options is matured (Options ITM)
The options is exercised! We are happy because we can purchase the stock/understanding at the strike price, which is $110. As we have received $2 as premium upon the selling of the put options, our cost base is reduced to $108 ($110 – $2). If compare to the Option #1, where we buy the stock at $112, by using options, we are now buying the stock at the cheaper rate, $108.
Warren Buffet loves to deploy this strategy to reduce cost base in acquiring great value stocks. this strategy improve the margin of safety further and allow the best use of capital to create income while waiting for the stock price to drop to fair/undervalue.
What should we do if Scenario 2 happens? Shall we just wait patiently for the stock price to appreciate or we can do something differently to further enhance our yield? I will share it in the next post! cheers!