With stock prices still down substantially from their 2007 highs, volatility levels high, and a number of companies trading at their lowest valuations in a decade, selling ("writing") puts can provide you with an opportunity to collect option premiums on stocks you would be happy to buy if the shares were sold -- or "put" -- to you.

In general, you have three primary motivations when you write puts:

  • Income: To make money while waiting for your preferred buy price on a stock.
  • Advantage: To buy stocks at a lower net cost.
  • Profit: To earn income from stocks you believe will hold steady or only increase modestly.

Example, please
Let's say you think Research In Motion (NASDAQ:RIMM) is a promising stock, and you'd be happy to own it below $70, but it trades for over $75 -- a bit too high in your opinion. Rather than place a limit order and hope the stock falls below your limit price, you could consider selling September $70 puts at $2.70 per share (or $270 per contract).

By selling one put contract, you agree to buy 100 shares of Research In Motion for $70 per share (a potential $7,000 outlay) at any point up to September 18, 2009, when they expire at market close. In exchange for assuming downside risk, the put buyer (who is likely trying to limit his or her downside risk) will pay you $270 per contract.

If Research In Motion shares close above $70 on September 18, you simply keep the $270 premium you received and are no longer on the hook to buy the stock. On the other hand, if Research In Motion closes below $70 by expiration, you take ownership of the shares at a net cost of $6,730 ($70 strike price -- $2.70 per share premium received) -- a price you were happy with when you entered the trade. As long as the stock doesn't close below $67.30 by expiration, it's been a profitable trade.

Or course, the stock could plunge, and therein lies the largest risk of selling puts -- imagine selling Citigroup (NYSE:C) $20 puts last year when shares traded hands for $24 (currently $2.70)! Ouch.

That's why it's crucial to perform proper due diligence and value the underlying businesses when selling puts -- just as it is when you buy a stock outright. As stock-focused options traders, it's unwise to write puts on bad stocks just because a particular option pays well. You want to know what the underlying stock is really worth. This not only reduces your downside risk on the option trade, but it also makes you comfortable with the company you're on the hook to buy if shares fall below the strike price.

Screening for green
So how do you find a company that fits the bill? A great tool is the CAPS screener, which scours the CAPS community's 135,000 investors and 3.4 million stock picks (and counting) to find investment ideas. In addition to finding great stock ideas, we can also use it to find strong candidates for writing puts. I screened for stocks with:

  • CAPS ratings of four or five stars (to improve our odds for finding a good company)
  • Market caps of more than $750 million
  • Price-to-earnings ratios below 15 (the S&P 500 average)
  • Price-to-book ratios below 2 (the S&P 500 average)
  • 3-year betas greater than 1.2 (higher volatility equals higher option premiums)
  • Long-term debt-to-equity below 50%
  • Return on equity greater than 10%

This screen spit out 46 companies -- but for now, let's take a closer look at three of the more well-known businesses (keep in mind that these are not formal recommendations):

Company

Industry

CAPS Rating

Titanium Metals (NYSE:TIE)

Industrial Metals

5 stars

Agrium (NYSE:AGU)

Agricultural Chemicals

4 stars

Baker Hughes (NYSE:BHI)

Oil & Gas Equipment and Services

5 stars

Tesoro (NYSE:TSO)

Oil & Gas Refining & Marketing

4 stars

Lincoln Electric (NASDAQ:LECO)

Industrial Goods

5 stars

Data from Motley Fool CAPS as of July 24, 2009.

At first glance, each of these companies shares some of the characteristics worth looking for when evaluating put-writing candidates. They're each free-cash-flow positive over the past 12 months, carry manageable levels of long-term debt, are undervalued relative to the market, and are supported by the CAPS community at large.

Next, let's check out some of the current put options available on the five stocks:

Company

Recent Share Price

Option Exp. Month

Strike Price

Premium (or Option's Bid)

Income % (Premium/Strike)

Break-Even Price on the Stock

Titanium Metals

$8.21

September

$7.50

$0.45

6.00%

$7.05

Agrium

$43.32

October

$40.00

$2.50

6.25%

$37.50

Baker Hughes

$40.69

October

$39.00

$2.40

6.15%

$36.60

Tesoro

$12.70

November

$11.00

$0.75

6.82%

$10.25

Lincoln Electric

$41.00

September

$40.00

$1.95

4.88%

$38.05

Data from Yahoo! Finance as of July 24, 2009.

Again, none of these should be taken as formal recommendations, but only as candidates for further research. That said, these are each worthy candidates. When we're looking at put options expiring in three months or less, we ideally want the strike price to be more than 4% below the current market price, and we want to receive a premium that's higher than 4% of the strike, together giving us a break-even price at least 8% below the current market price. With the sole exception of Lincoln Electric, which just fell short of meeting the second condition, each fulfills these conditions.

If any of these five put-writing candidates piques your interest, the next step is to do a business valuation to determine whether or not you'd be comfortable owning the stock at these potential strike prices.

Foolish bottom line
Options -- calls and puts -- sometimes get a bad rap for being "speculative" -- and they can be -- but used in the context of a stock-focused, long-term investment portfolio, they can help you improve your returns, reduce risk, and generate portfolio income.

Hopefully this article has helped shed some light on how to approach put writing. Want to learn more? We're launching a video series designed to get you up to speed on options basics. Just enter your email in the box below for access -- it's completely free.

Todd Wenning now returns you to your regularly scheduled program. He does not own shares of any company mentioned. Fossil is a Motley Fool Hidden Gems recommendation. The Fool's disclosure policy rocks on with its bad self.