Get Paid While You Wait for Stock Bargains

The ongoing rally in stocks has made everybody happy -- except for investors who'd hoped to pick up bargains on the cheap for a while longer. If you're getting ready for a pullback, though, there's an easy strategy that will actually pay you while you wait for stock prices to get more attractive.

Put writing 101
Many investors automatically feel uncomfortable whenever the subject of options comes up. Yet although options have a reputation as being used solely by speculators, that's not the only use they have; options can also help you carry out very specific investing strategies. Writing put options is one example.

When you sell a put option, you pick the price you're willing to pay for a stock. It's up to the person who buys your put option to decide whether or not to sell the stock to you, within the limited time before the option expires. The buyer pays you a premium in exchange for your commitment. Even if the buyer never exercises the option, you still get to keep that premium.

How it works
Suppose your favorite stock is Microsoft (NASDAQ:MSFT). You're not entirely comfortable paying its recent price around $23.50. But if shares dropped to, say, $21, you'd be getting enough of a bargain to have a margin of safety for your investment.

You could write a put option, obligating you to pay $21 apiece for Microsoft shares anytime between now and the middle of October. Based on recent prices, you'd get about $0.97 per share, or $97 for each 100-share option contract you write.

By mid-October, one of two things would happen:

• If your option isn't exercised, then you just get to keep the $97.
• If it is exercised, you'll have bought 100 shares of Microsoft at $21 per share, less the $97, for a net cost of $2,003, or $20.03 per share.

The table below shows more examples of what you could get by writing put options.

Source: CBOE. Prices as of June 15 close.

The downsides of put options
Obviously, writing puts has some advantages over simply waiting for stock prices to retreat -- most notably, the premium you're paid. But there are two major downsides to put writing.

First, once you've written a put, you should be prepared to buy the stock at the strike price; if you change your mind, you'll have to actually go out and buy the option back, potentially paying more than you initially received when you wrote the put. That can be a harsh price to pay, if whatever bad news caused the company's shares to fall also makes the stock less attractive to you.

Second, selling put options doesn’t guarantee that you’ll receive shares even if they hit your strike price, because put buyers decide if and when they'll exercise their options and sell you their shares. Even if a stock drops, it may rebound before your put expires -- and if it does, you may never pick up any shares. You'll still pocket the premium, but you'll have missed out on the additional gains from owning the stock.

The bottom line is that you want to make sure that the premium you receive adequately compensates you for the risk that the stock falls sharply, on the one hand, or that it takes off and leaves you behind. So long as you’re getting a good price, writing puts can be a great way to get paid while you wait for stock bargains.

Learn more
Put writing has its place in your arsenal of investing tools. As long as you understand the risks involved, writing put options can give you a great combination of guaranteed income and the potential to buy superb stocks at bargain prices.

Writing put options is just one method that our Motley Fool Pro service has used to deliver market-beating returns since its launch last October. For just a few days, we're reopening the service to new members. If you're interested in learning more about some of the strategies we’re using to help us make money in any market, simply enter your e-mail address in the box below.