I'm Cameron May and this is "Comment Below."
All right, so for today's question,
Fizbalaban says, I have a question.
Isn't a limit order essentially the same as selling a put?
With the exception that you actually get paid for time
spent waiting.
What advantages does a limit order to buy
have over selling a put?
All right, Fizbalaban, I think you've asked a great question.
I think a number of self-directed investors
might be asking themselves the same thing when they first
hear about this concept known as selling a put,
and they compare it to a limit order to buy.
All right, so let's explore this concept called a limit order.
Let's suppose that you've stumbled on a stock, XYZ.
It's trading at $100 per share.
But you'd like to buy it if it slips down to $95 per share.
Well, a trader can actually just enter in order to buy for $95.
That's called a limit order.
In other words, that's the limit that you would
prefer to pay for the shares.
And they might want to remember to also enter that as a good
till cancelled order.
All right, so Fizbalaban, let's make a deal.
Rather than you just going out and putting in an order
to buy the stock at $95.
How about if I pay you $2, and in exchange,
you would agree to buy my shares of XYZ company
for $95 at some point in the next 30 days,
entirely in my discretion?
So what we've just done is entered
into a legally-binding contract to exchange shares.
One important point though, is that this is for 100 shares.
So it's not just $2, but $200.
That's known as selling a put.
You've sold me your promise in exchange for $2,
and I have the right to put my shares
into your account at my time and at my discretion.
Now, where can this stock go from here?
Stock's trading at $100.
What happens if the stock goes up?
Well, in that case, let's say it goes up to $105.
I'm going to retain my shares.
You can have my $2.
And compared to that limit order,
you come out of this smelling like roses,
because you got paid $2 and had no obligation as a result.
So that's one potential outcome.
And that's let's say, a win in the win
column for selling a put.
But what if the stock goes down?
Stock's trading at $100.
It slips $97, $96, and you're reconsidering
the wisdom of the trade and you want out of the deal.
With a limit order, you just cancel the order.
No harm, no foul.
However, having sold me the put, you
might have to buy that put contract back from me.
And you may have to pay me more than the $2 that I
paid you upfront.
So there's certainly the potential for a loss
right from day one when selling puts versus the limit order.
But now, let's explore what happens
if the stock falls below $95.
You might think, oh good, this is where I get my shares.
Well, hold on.
Not quite.
That's in my discretion.
Maybe I haven't decided to sell you those shares yet.
I want to see what they do from there.
And let's suppose the stock rallies.
Well, had we had that limit order in,
it's very likely the order would've filled.
You would own the shares and be participating in that rally.
However, because we sold that put,
maybe I, as the owner of that put
have not sold you the shares.
I'm keeping them.
You're sitting on the sidelines and watching
as the stock is rallying.
So that's another important distinction.
Now, what happens if the stock falls to $90.
At that point, maybe I decide to exercise my right
to sell those shares to you at $95.
You're buying at $95.
They're only worth $90.
You have an unrealized loss of $5, however,
you do have my $2 in your pocket.
So really, down only $3.
Compare that to the limit order to buy.
Had you purchased at $95.
Shares are worth $90.
You'd be down $5.
That sort of tilts the scales in this situation
toward selling the put.
There are a few more important things that we need to discuss.
Number one is that maybe your plan
was not to buy at a nice round number like $95.
And instead, you were looking to buy
if the stock happened to slip down to some price like $97.32.
Well, it's quite likely that there
are no puts available at that price.
In reality, most option strike prices are listed in round
incremental numbers like $1, $5, $10, maybe sometimes $2.50.
And you're pretty much stuck with what you get.
Trading a put requires that you trade
in 100-share lots, which is not a requirement of the limit
order.
One other thing that I have to mention
is that some people are just flat out not comfortable
with options, and so they might prefer the limit order
simplicity.
Plus, traders have to get approval to trade options.
So Fizbalaban, I hope this has been helpful in showing you
the distinctions between using a limit order to buy
and selling a put, even though at first glance,
they can appear to be very similar approaches.
OK, so if you have more questions for our coaches,
you can tweet us or comment below.
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