How to Profit From Fear

It's been a full year since Bear Stearns imploded and the market decline began. I'm sure you haven't enjoyed the experience of watching your portfolio get thrashed over the past 12 months. I know I haven't.

If you could pay someone to make what's left of your portfolio more secure, would you?

Because you can.

The obvious strategy
You can protect your downside risk by buying put options on the stocks you own. A put option gives you the right to sell your stock at a certain price by a certain time.

For a small fee, then, you're guaranteeing yourself a temporary price floor for your stock -- which is comforting when the market keeps falling down, down, down.

But buying puts to protect your downside risk would have made much more sense when the market was riding high. With the S&P 500 nearly 50% off its May 2008 peak, buying puts will only pay off if the market gets much worse from here.

Instead, you can take the opposite position and sell puts to make the fear of your fellow investors work for you.

Meet the put writer
See, despite the fact that downside risk has already manifested itself in all of our portfolios, scared investors are still willing to pay for that protection by buying put options -- and they're more willing than they usually are.

According to Investor's Business Daily, on March 16, the ratio of price premiums in puts versus calls stood at 1.37, down from 2.58 at the peak of market panic in October, but still more than double the 52-week low of 0.62 in May.

And that bearish sentiment means that now is an ideal time to be a seller, or "writer," of put options.

The put seller stands on the other side of the put option transaction, pockets the small fee the buyer pays, and is obligated to purchase the buyer's shares at that predetermined "strike" price and time -- if the price falls below the strike price set by the option.

For example, let's say you think Apple (NASDAQ:AAPL) is trading at a good -- but not great -- price today at $98, and you'd much rather buy it below $90. You might consider selling the October 2009 $90 puts for a premium of $9.30.

This means that for each put contract you wrote (each contract represents 100 shares of Apple stock), you would collect $930 and be on the hook to buy 100 shares of Apple stock at $90 ($9,000 worth) if the stock fell below the $90 strike price by the option's expiration on October 16.

If Apple shares did fall below $90 on October 16, your net purchase price, or break-even, would be $81 per share ($90 - $9). In other words, you got paid to buy a stock you wanted to own anyway. Sweet deal, right?

Put selling commandments
Of course, there are some risks with selling puts. The best worst-case scenario is that Apple shares take off between now and October and you miss your opportunity to buy it at today's prices -- but at least you still have the $930 premium cash in your pocket.

The worst worst-case scenario is that Apple falls well below your break-even price of $81 by October, but you're still on the hook to buy the shares at a higher price.

Reducing the odds of selling a bad put comes down to two things:

• Make sure you're getting paid enough for the risk you're taking.
• Only sell puts on stocks you consider undervalued.

When you sell puts, you're assuming the downside risk and should therefore seek to be properly compensated for that risk -- which means creating a significant margin of safety through the strike price (which should be sufficiently below the market price) and the premium you'll earn.

You must also be happy and willing to buy the shares if you're assigned (forced to buy) the shares at or before expiration. This means you need to do your research and determine a proper valuation for the stock you're selling the puts on. The last thing you want to do is be obligated to buy a stock at a price still well above its fair value.

Worthy candidates
In this market, many stocks are undervalued, giving you a nice pool of high-quality businesses to work from.

A quick screen of S&P 500 stocks trading with price to free-cash-flow ratios below 10 provides a starting point for further research:

Data provided by Capital IQ, a division of Standard and Poor's, as of March 17.

While none of these should be considered formal stock or options recommendations, their already-low valuations and their ability to churn out gobs of free cash flow make them reasonable candidates for put writing.

Be prepared
Put selling isn't for everyone. In fact, most brokers require you to have prior experience with options and sufficient buying power in your account before they'll approve you to sell puts. After all, if you don't have enough money to buy the underlying stock at expiration, it can wreak havoc on the rest of your portfolio.

But if you do have some experience with options and the funds to spare, you can profit from all of the investor fear by selling puts on healthy businesses with attractively valued stocks. Done correctly, selling puts will generate income and get you stocks at better prices.

In our Motley Fool Pro investing service, we've been finding many opportunities to sell put options to better our bottom line -- by generating premium income and buying stocks at lower prices. If you'd like to learn more about our strategy for making money in all types of markets -- including this one -- just click here.

Pro analyst Todd Wenning would like to recognize Ronnie's Bagels in Hillsdale, New Jersey for making the best bacon, egg, and cheese sandwich in the world. He does not own shares of any company mentioned. United Parcel Service is a Motley Fool Income Investor pick. Walt Disney and Microsoft are Inside Value recommendations. Apple and Walt Disney are Stock Advisor picks. The Fool's disclosure policy takes its sugar with coffee and cream.