I have learned a lot about investing from Derek Foster’s books and wanted to like his strategy of making money relatively risk-free on the options market. Unfortunately, it just doesn’t seem worthwhile to me.
The strategy is quite simple: you collect a commission by agreeing to buy a share at a lower price in the future. This is called selling a put option. The reason you get a commission for it is because the person who currently owns the shares is essentially buying insurance to protect themselves if the share price drops in future, and you are the one agreeing to buy the stock if the share price drops.
This theory sounded great, I could collect money for doing essentially nothing and only have to pay up if a stock I already like and want to buy comes down in price. I like buying stocks on the dip.
Canadian stock options are traded on the Montreal exchange and information about the options are found here. For stocks trading on US exchanges, they are listed at Yahoo Finance
The options page for a stock I like, Royal Bank (RY:T), is here
Where this system falls short for me is that you have to trade in lots of 100 shares. Royal Bank currently trades at about $76 per share. I can sell January 2016 puts at $70 a share and I would get a premium of $2.07 per share now for agreeing to make a purchase of Royal Bank shares if they drop to $70 a share between now and the third Friday in January of 2016. For the 100 shares, I would collect $207. Where I run into trouble is that if the price does come down to $70, I will immediately need to fork over $7,000 to buy the Royal Bank shares. As much as I like Royal Bank, buying that many shares is a little out of my league. I could instead go with the January 2016 options at $56 for 37 cents per share. That means a commission of $37 now, and I would be obligated to pay $5,600 if the shares drop to $56. It’s not terribly likely that it would happen, but it is a possibility.
So then, what if I did it with a cheaper stock? Well, the blue chip, dividend-paying stocks are generally more expensive. I wouldn’t want to use this strategy on a more speculative investment. If I tried it with a cheaper dividend payer like Riocan (REI.UN:T), currently trading at about $27 a share, it has January 2016 $24 puts available at 25 cents. This means the commission I’d earn is $25 and I’d be obligated to buy $2,400 worth of Riocan shares if the price fell to $24.
I’m just not crazy about those numbers as the commission I’d earn isn’t great considering I’d be looking at paying my broker about $10 to execute that trade for taking on that level of risk.
The other downside of this strategy is that I can’t play the game in my RRSP, it would have to be done with non-RRSP funds.
I suppose Derek Foster would counter that I would do this in a margin account on a line of credit, where I pay about prime plus 2-3% (prime is currently 2.7%),and if Royal Bank stock dropped that much it would have a dividend yield of nearly 5%, which would pay my interest costs on owning the stock while waiting for the price to rebound.
It’s all a great theory, but I don’t have the stomach for those kinds of numbers!