Get Paid to Bottom-Fish

In a plunging market, bottom-fishing is both tempting and dangerous, at least in the short term. But if you're willing to commit to buying a stock, you can get someone to pay you for your promise -- even if you'd only buy at a much lower price.

Yesterday, I wrote about how you can pick up bargain shares of temporarily beaten-down stocks by setting limit orders. With a limit order, if your stock's price ever drops to the price you choose, you're already in line to buy shares -- even if it's a week or a month after you place your order.

However, there's another way to pick up cheap stocks. Using an investment strategy involving options, you can agree to buy shares at whatever price you choose. Better yet, you'll get paid while you're waiting to see whether they ever fall far enough to interest you.

The basics of put writing
When the subject of options comes up, many investors immediately feel out of their comfort zone. But options aren't just for speculators; they can also help you carry out very specific investing strategies. Writing put options is one example.

By writing a put option, you agree to pay a certain price per share for a stock over a fixed period of time, as long as the person who buys your put decides to sell to you. In exchange for your agreement, the put buyer pays you a premium that you get to keep, whether you end up buying the shares or not.

An example
Suppose your favorite stock is Apple (Nasdaq: AAPL  ) . You're not entirely comfortable paying its recent price around $96. But if shares dropped to, say, $80, 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 $80 apiece for Apple shares anytime between now and the middle of December. Based on recent prices, you'd get about $3.70 per share, or $370 for each 100-share option contract you write.

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

  • If your option isn't exercised, then you just get to keep the $370.
  • If it is exercised, you'll have bought 100 shares of Apple at $80 per share, less the $370, for a net cost of $7,630, or $76.30 per share.

Right now, option premiums -- as measured by the VIX volatility index -- are fairly high, rewarding those willing to take the risk of having to buy stocks in a bear market. The table below shows more examples of what you could get by writing put options.

Stock

Recent Price

Expiration and Strike Price of Put Option

Premium

Microsoft (Nasdaq: MSFT  )

$21.30

Jan. 19

1.08

SINA (Nasdaq: SINA  )

$30.99

Dec. 25

1.00

Starbucks (Nasdaq: SBUX  )

$10.20

Jan. 8

0.56

Research In Motion (Nasdaq: RIMM  )

$46.58

Dec. 40

3.30

Chesapeake Energy (NYSE: CHK  )

$23.67

Dec. 20

1.75

Yahoo! (Nasdaq: YHOO  )

$11.87

Jan. 10

1.25

Source: Yahoo! Finance, CBOE as close of Nov. 10, 2008.

The downsides of put options
Obviously, writing puts has some advantages over a simple limit order -- most notably the premium you're paid. But there are two major downsides to put writing.

First, once you've written a put, you can't just change your mind if the stock falls. 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. In contrast, with a limit order, as long as the share price is still above your limit price, you can simply cancel your order.

Second, put options require much better timing. A limit order can execute anytime the markets are open. But options give you no such control -- put buyers decide when and if they'll exercise their options and sell you their shares. Even if a stock drops, if it rebounds before your put expires, odds are good you won't get any shares. You'll still pocket the premium, but you'll have missed out on the additional gains from owning the stock.

Keep it simple
Both put writing and limit orders have their 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.

More on interesting ways to invest now:

You don't have to use options to find great bottom-fishing opportunities. At Motley Fool Inside Value, we're always looking for high-quality stocks at good prices. See the bargains we've discovered absolutely free with a 30-day trial.

Fool contributor Dan Caplinger writes puts from time to time. He owns shares of Starbucks and Chesapeake Energy. Starbucks, Microsoft, and Chesapeake Energy are Motley Fool Inside Value selections. SINA, Starbucks, and Apple are Motley Fool Stock Advisor selections. The Fool owns shares of Starbucks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy tells all.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 11, 2008, at 2:35 PM, juliehowe wrote:

    Good article. Very informative. Thank you.

  • Report this Comment On November 12, 2008, at 5:35 PM, Bristinwolfsong wrote:

    I would love to try this strategy but I cannot seem to convince my broker to give the the ability....I may be trading brokers soon seems a shame as I have been with Etrade now for nearly 10 years

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