The Closest Thing to Money for Nothing

There's no such thing as an absolutely free lunch, and anyone who offers one isn't telling you the whole story. But there's one investing strategy that's almost as good as a free lunch -- and as long as you understand the risks involved, you might end up making huge profits by using it.

Waiting for bargains
A lot of people think that in order to be a good investor, you always have to be doing something with your money. Money on the sidelines is money wasted, their thinking goes, and it's impossible to stand out from the crowd if you don't place your bets on one stock or another.

The best investors, though, aren't afraid to stay out of the market when the odds are against them. Value investors, for instance, may occasionally find stocks that offer good value even when nearly every other stock in the market is overpriced. But for the most part, they shy away from red-hot markets, keeping their ammunition dry for when the inevitable turning point comes. It's that patience and discipline that set Warren Buffett and other successful value investors apart from the rest.

Having that patience is hard. But wouldn't it be a whole lot easier if you were getting paid while you wait?

Enter options
That's where put options come in. When you talk about puts, a lot of people think about them from the buyer's perspective, in that they can help you protect your portfolio from losses if your stocks lose value.

But by writing puts -- in other words, selling them to people looking for that protection -- you can earn income and put yourself in a position to own high-quality stocks at attractive prices. Even Buffett has done it from time to time. Here's how it works:

• Find a stock that looks like a good investment but whose shares are too expensive at current levels.
• Figure out how low the stock price would have to go in order to make those shares attractive to you.
• Write a put option that will obligate you to pay that lower price within a certain period of time.

When you write the put option, you receive a premium from the person who buys the option from you. In some cases, you can earn a lot of money from the premium payments you get when you write puts. Here are some examples:

Source: CBOE. Based on closing prices as of Dec. 7.

As you can see, obligating yourself to buy shares on the cheap for three to six months will often earn you between 3% and 5% or more of the share price. That money's yours to keep, no matter what happens to the stock price. If shares rise or stay stable, then you simply pocket that cash as your profit. If the stock drops, then you'll buy shares -- but only at the price you chose, and you still get to keep the premium to offset your total cost.

No downside?
If you're skeptical, you're right to be. There's one catch: Writing the put option obligates you to buy the shares if they drop, before you know the cause. Often, the news that pushes the share price lower might make you want to change your mind about buying the stock. If you already wrote the option, though, it's too late -- you'll be stuck with the shares.

But if you're truly committed to buying the stock anyway no matter what, then writing a put option is a great way to get some extra cash for your trouble. In the end, every little bit of extra profit helps.

Learn more
Options offer many unique ways to profit. Motley Fool CFO Ollen Douglass recently made more than $100,000 with a simple options strategy involving six well-known stocks, and he's looking to our Motley Fool Options service for real-money advice on what to do with his profits. To learn more about strategies like writing puts -- as well as Ollen's story -- just enter your email address in the box below to ensure you'll get the latest information.