A thought experiment –
Lets assume you find a stock which is undervalued and it is liquid (otherwise you may not get options on it). You buy the stock and would continue to buy if the price were to drop further (the critical point). In addition you sell puts for strike price say, 20% below the current price.
If the price does not drop, you keep the premium and reduce your cost basis. If the price drops by more than 20%, the put gets exercised and you buy the stock (which you any way planned to do so).
The key objections to this strategy could be
· Does not work with illiquid, lesser known stocks which are more likely to be undervalued
· if the price drops more than the strike price, say 30% then I am losing out on the additional 10% cost of the stock . In worst case scenario if I have mis-analysed the stock I could be in a lot of trouble as I may end up incurring huge losses in that scenario.
· Someone has to be ready to buy these puts (puts should be saleable)
· Stock has to be volatile enough to make the puts attractive and worth the effort
· Contract size – Does the contract size fit with the investment plan. May not work out for an investment plan of a few hundred shares in some cases
A few other cases
· Buying undervalued stock and sell calls at 60-70% above strike price
· Buying long term options on a stock (LEAPS in the US ..not sure if available in India)
I have analysed a few cases such as the above in the past. However once I have looked at the possible scenarios which can play out, done an expected value analysis and compared it with the cost, most of the cases turn out to be low in returns and moderate to high in risk.
Please feel free to comment on the above strategy or any better ones you may have tried.