When we think about stocks, we think about growth. We buy stocks because we expect to sell them later at a higher price. The problem is in timing the entry and exit points, as we often get sidetracked by the emotional roller-coaster of the stock market.

A better approach is to avoid trying to time the market and focus instead on accumulating quality stocks at reasonable prices.

Writing puts is one systematic way to set a price for acquiring quality stocks over specific time periods. For example, say you are interested in acquiring shares of Suncor Energy Inc. but believe that its recent price of $33.08 a share is too high in the current environment. You could write the Suncor December 32 puts for $2.05 a share. The sale of the put obligates you to buy Suncor at $32 a share until the December expiration.

Having received $2.05 a share in premium income, your net cost, if the put is assigned, is actually $29.95 ($32 – $2.05 = $29.95) per share. With this strategy, you have set an acquisition cost that you can be reasonably comfortable with.

A concern with naked puts is the downside risk. The obligation to buy shares means that you might have to pay for a stock that, theoretically, has fallen to zero. And although quality stocks are not likely to fall to zero, they can be subject to extreme bouts of volatility that can unnerve even the coolest investor, which could cause you to exit the naked put position prematurely. Just ask anyone who had sold puts on BP PLC prior to the oilwell explosion in the Gulf of Mexico.

If you want to eliminate the risk of being blindsided by an unpredictable event, you could extend the concept of put writing to the “bull put spread.” With Suncor as our example, you could write the December 32 put and, at the same time, buy the Suncor December 27 put at $0.70 to hedge against a worst-case scenario.

The net premium received from the Suncor 32/27 put spread is $1.35 (the $2.05 premium from the December 32 put minus the $0.70 cost of the December 27 put = $1.35 net premium received). Taking this spread position to the point of assignment, your net cost — if Suncor is put to you — is $30.65 ($32 strike price minus $1.35 net premium). That’s still well below the $33.08 trading share price at the time of writing, and with a worst-case scenario precisely defined.

If Suncor is trading above $32 in Decem-ber (the reason you would be willing to acquire the stock in the first place), both your puts would expire worthless but you would retain the $1.35 net premium received.

Which is to say: the put spread profits if Suncor rises, stays the same or even declines slightly — in this case, as long as the stock remains above the net $32 entry price by the December expiration.

If Suncor drops sharply because of a catastrophic event, you would be required to buy shares at $32 each ($30.65 a share net cost after accounting for the net premium received). But you also retain the right to put those shares to someone else at $27. Your maximum risk then, is $3.65 a share.

It is the limited cost associated with catastrophes that makes this spread position particularly interesting. Effectively, this bull put spread precisely defines your entry point regardless of the current price of the underlying stock.

For example, let’s assume that Suncor fell to $15 a share by the December expiration. With the bull put spread, you would be required to buy shares at $32 (really $30.65 after accounting for the net premium received). But because the stock is at $15 a share, you can put the stock to someone else at $27. Your long December 27 puts would be trading at $12 a share ($27 strike price minus current price of $15 = $12).

When you wash this through a calculator, the net cost of purchasing Suncor, at that point, would be $18.35 ($30.65 net entry price minus $12 return from the sale of the December 27 puts = $18.65 net purchase price).

In this scenario, you end up with the stock at a net price that is never more than $3.65 above the current market price, which makes this an excellent approach for clients who want to avoid the emotional roller-coaster while accumulating a portfolio of quality stocks over time.

It also provides a template for deciding whether you actually want to own Suncor at the December expiration. It may be, with the stock having fallen to $15 a share, that the reasons for buying it are no longer relevant. In which case, you would walk away with your pocketbook
intact.

IE