How to Profit From Fear

After experiencing the sharp market decline of the past 18 months, if you could pay someone to make 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 is falling.

But buying puts to protect your downside risk makes the most sense when the market is optimistic. Even though the market has recovered nicely from its March nadir, it is still well off its lofty 2008 highs.

Instead, when the market is overly-pessimistic, you can take the opposite position and sell puts to make the fear of your fellow investors work for you.

Meet the put writer
As we saw last fall and winter, scared investors are willing to pay a princely sum to protect their portfolios.

According to Investor's Business Daily, on October 6, 2008 -- at the height of the banking panic -- the ratio of price premiums in puts versus calls stood at 2.58, which remains the five-year high. For reference, the ratio's five-year low was 0.34 in January 2008 when optimism was running amok -- a great time to have sold, in hindsight.

Today, that put/call ratio is just 0.79, indicating much more bullishness than in March when it stood at 1.37. So, while now might not be the best time to aggressively sell puts, it's worth getting to know the strategy so you're prepared if the market takes another downward turn.

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 eBay (NASDAQ:EBAY) is trading at a good -- but not great -- price today at $22, and you'd much rather buy it below $21. You might consider selling the October 2009 $21 puts for a premium of $1.20.

This means that for each put contract you wrote (each contract represents 100 shares of eBay stock), you would collect $120 and be on the hook to buy 100 shares of eBay stock at $21 ($2,100 worth) if the stock fell below the $21 strike price by the option's expiration on October 16.

If eBay shares did fall below $21 on October 16, your net purchase price, or break-even, would be $19.80 per share ($21 - $1.20). 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 eBay 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 $120 premium -- cash in your pocket.

The worst worst-case scenario is that eBay falls well below your break-even price of $21 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, there are still a number of attractive buying opportunities, 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 15 provides a starting point for further research:

Data provided by Capital IQ, a division of Standard and Poor's, as of July 29.

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.

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.

This article was originally published on March 18, 2009. It has been updated.

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 owns shares of Home Depot. eBay is a Motley Fool Stock Advisor pick. Dell, eBay, and The Home Depot are Motley Fool Inside Value selections. The Fool's disclosure policy takes its sugar with coffee and cream.