Many investors have waited on the sidelines for years as the S&P 500 (SNPINDEX:^GSPC) has hit new all-time record highs and as many stocks throughout the market have risen to extraordinarily expensive levels. Maintaining the discipline to wait for good prices is tough, but it's important to ensure you don't overpay for stocks right before they decline.
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. Using an option-based strategy that involves writing put options, you can earn extra cash while setting the exact price at which you'd be willing to buy cheaper stocks.
Put your money where your mouth is
The basics of the put-writing strategy are simple. Writing a put option is the same thing as selling it, with the buyer paying you for the right to sell you shares at the option strike price you agree upon. Whether or not you end up buying those shares from the put-buyer, the money you got paid is yours to keep.
Essentially, what you're doing with put-writing is taking the opposite side of the trade from someone seeking to protect their portfolio from a downturn. Conversely, if you'd be buying stocks or an index fund anyway if the stock market dropped, there's no harm in accepting extra payment for committing to that course of action in the future.
In fact, one additional benefit of writing put options is that they take the future decision out of your hands. Most value investors talk about how they'd be happy to buy stocks if they fell to certain levels. But when push comes to shove and those drops actually happen, it can be hard to pull the trigger. Put options don't leave you that choice.
Looking at options on the SPDR S&P 500 ETF (NYSEMKT:SPY), committing to buying the ETF at levels 10% below the current price anytime between now and mid-December would net you about $1.80 per share -- or slightly more than 1% of the current share price. That might not sound like much, but if a shares don't drop that low between now and December, you can keep the $1.80 per share and write another put option, reaping even more income while you wait. With interest rates at rock-bottom levels, income from put-writing takes on added importance.
What to watch out for
The key, though, is to make sure that you're entirely comfortable buying the market after a decline -- no matter what caused it. Put-writing for a specific stock can be dangerous because the event that causes a price decline often changes the fundamental rationale for buying the stock, leaving you stuck with shares you no longer want. With the broad market, though, it's harder -- though not impossible -- to envision an event that would sour you on stocks generally.
Still, the extra income that put-writing generates is a key advantage over other bottom-fishing techniques. That makes the strategy well worth considering for many investors looking to pick up bargain stocks in the future.