After two years of rallying stocks, it's hard to find true bargains in the stock market. Rather than jumping in at any price, value investors prefer to wait for inevitable corrections to pick up stocks on the cheap.
But as disciplined investors know, sometimes you can wait a long time for a bull market to give way. Fortunately, if you're willing to commit to buying a stock at a discount price, there's a way you can get paid while you wait for stock prices to get more reasonable.
Get paid to wait
This week, we've looked at a variety of investing methods using options. Call options can either give you a way to bet on a continuing rally or boost your income, while buying put options can protect your portfolio from losses or let you make money from a market sell-off.
But another options strategy is designed to let you establish the price you want to pay for a stock. By selling put options, you can pick up bargains if they come while getting paid no matter what happens.
Here's how it works. When you sell a put option, you give the put buyer the right to sell shares of stock to you for the price you agree upon. In exchange for committing to buy those shares if the put buyer exercises the option, you receive a premium. That premium is yours to keep, regardless of what the put buyer decides to do.
An easy strategy
In other words, you're taking advantage of the fact that other investors want to buy put options as protection against a downturn. Conversely, you want that downturn to happen so you can pick up shares on the cheap. So to make the most of the strategy, here's a simple three-step plan:
- First, identify stocks that you like but whose prices are too high.
- Second, decide what you're willing to pay for those stocks.
- Last, write put options with a strike price around your desired purchase price.
So how do you identify good stock prospects? As I did yesterday, one choice is to turn to our Motley Fool CAPS service, this time searching for top-rated five-star stocks that have gained at least 40% in the past year. Here are some of the stocks that pass the test, along with how much you'd receive for selling a put option at a price around 25% lower than where the stock currently trades:
||$52.85||Jan. 2012 $40||$1.23|
Sources: Motley Fool CAPS, Yahoo! Finance. Prices as of March 10.
Committing to buying these stocks at a 25% discount to their current price any time during the next three to nine months or so can earn you between 1% to 3% of the current share price. If the stock stays above your target price, then you simply keep the money you earned from selling the put option. On the other hand, if the stock drops enough, then you'll get to pick up shares at your desired price -- plus keep the option premium as your free bonus.
What's the catch?
The danger here is that you have to be absolutely certain you'd want to buy the shares after a drop, no matter what caused prices to fall. That may sound fine now, but if a company-specific piece of news is responsible for your target company's stock tanking, then you might not be as optimistic about the company's future prospects as you were before the news came out.
That's why it's important to pick stocks you'd be happy to own no matter what. That way, the cash you receive from selling the put option is just icing on the cake -- what you're really hoping for is a pullback big enough to get a nice bargain.
Use all your options
I hope you've enjoyed this weeklong series on options. Options are scary to many investors, but once you understand them, they can help you broaden your comfort level in your investing and take advantage of opportunities that those who stick with stocks and mutual funds can't use. That alone makes learning about options worth the effort.
To learn even more about options, be sure to check out our Options Center. You'll find a tutorial on options and much more.
If you're interested in following any of these stocks as potential bargains, add them to your watchlist. Don't have one? Sign up now and get immediate access to a new special report, "6 Stocks to Watch from David and Tom Gardner." Click here to get started.
Fool contributor Dan Caplinger has gotten a lot more patient over the years. He doesn't own shares of companies mentioned in this article. The Fool owns shares of Denbury Resources, EMC, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never makes you wait.