After years of hearing that stock options are just risky speculation, you might be surprised to hear that stock options, used strategically, can be investing tools that work strongly in your favor. But it's true. I'd been investing in stocks more than 10 years before I considered options, but now I use them systematically and feel they certainly have their place for interested investors.

My favorite use of stock options is for income generation -- straight cash generation -- while waiting for a stock to decline to a price where I'd want to buy it. I'll explain.

First, if you haven't and need to, please read our last two week's articles, introducing stock options and buying options. Today, we get to a strategy that interests me most: Selling, or "writing," options.

Options aren't for all
We'll start with a disclaimer, using the words of Fool writer Zeke Ashton in the Fool's guide to options:

I want to reiterate that our coverage of options and option strategies should in no way be taken as an endorsement that options are for everybody. I would never recommend that any option or option strategy be used by casual investors. In addition, those who don't handle volatility well should not even think about using options. You can live a long and satisfying investing life without ever having bought or sold an option, but it's good to know what's out there. If you do decide to take the plunge, do yourself a favor: Go slow, start small, and give yourself a chance to advance along the learning curve without losing your shirt.

I'll add to this that you should have a valid reason for using any option -- a logical, "wholistic" strategy that includes stock ownership. Because if you're merely speculating on price movements, you will get burned. The following is one such strategy.

Getting paid while you wait
Assuming that your brokerage account meets requirements, anyone can sell (or write) an option at the going bid price. You needn't own the underlying stock to do so. When you sell an option, you receive all of the premium, or the price that the buyer paid, minus a trade commission. The premium immediately arrives as cash in your account and is yours to keep (minus taxes).

Now, you're old enough to know that if you're receiving money, you're doing something to merit it. In the case of selling naked puts (and naked just means you don't own the underlying stock), you're being paid for one reason: You're promising the option buyer that you'd purchase a stock from him at a certain price by a certain date.

Why would you make this promise? Well, for very good reasons. You sell a naked put if you'd like to buy the underlying stock at a certain price anyway. Let's use an example.

Imagine that you wish you'd bought 1,000 shares of Millennium Pharmaceuticals (NASDAQ:MLNM) recently at $10. The company had its cancer drug, Velcade, approved this month and the stock has risen to $15. You think the 50% jump is steep, so you aren't comfortable buying shares now, but if the stock returned to $10 you'd want to buy it. So, you could just sit and wait. Or, you could get paid to wait.

Today, you can sell January 2005 Millennium puts with a $10 strike price for $1.55 per contract. Being the seller of the put, you promise the put buyer you'd purchase the stock at $10 should it decline to that price or lower. For that promise, you're paid $1,550 per 1,000 shares (or 15.5% of your total eventual purchase price). So, you'd collect $1,550 cash minus an average $30 commission. Then you'd wait.

Some possible outcomes:

1. Millennium rises to $25 and the put option you sold expires (because the put owner has no interest in selling shares at $10, of course). You missed the rise in the stock, but at least you made $1,550 for the option sale without committing any capital.

2. Millennium falls to $9.00 and the put holder exercises his option, selling you 1,000 shares at $10. You still keep your premium ($1,550), so you really only paid $8.45 per share, and you now own your desired stock position at that cost basis -- even lower than the $10 you would have bought at.

3. Millennium tanks to $7 and you're "put" (meaning sold) the shares at $10. After your premium, you've bought your shares at $8.45, so you're down $1.45 per share. Still, you'd be down $3 per share had you bought at $10, as you had wanted. Now you can hold and hope for the stock to rebound.

As you can see, if you would only be comfortable buying a stock at a lower price than it currently trades (so you won't regret too much if it keeps rising without you), then selling puts and waiting for your price can be much better than simply waiting and hoping. You receive income while you wait and you can ultimately buy the stock below your target price, given the premium you're paid.

Additionally, human nature being what it is, many of us become hesitant to buy a stock as or after it declines (exactly when we should be buying good companies). Once you've sold a put, though, you're all but forced to buy the stock at the lower price, should it fall. This has worked out well for me, as the stock later rebounds. (Note that you could buy back the put you sold -- at a loss -- to close your position without buying the stock, but that defeats the whole purpose of this strategy.)

So, selling puts is a way to potentially buy a desired stock at a lower price and get paid something whether you do or don't. Some investors also sell naked puts every month as a means to generate steady income. Selling a naked put in this case is a bullish move. You're guessing that the underlying stock will rise (or not decline) and the "out-of-the-money" (or below market price) put that you sold will simply expire, meaning you get the premium and needn't take any action.

This is a valid strategy only if you want to own the underlying stock anyway, and would be happy to buy the stock should your strategy not pan out. In the sale of any put, in fact, you must be 100% ready to buy the stock because it could be sold to you at any time (if the stock falls below the option strike price), not just the month of expiration.

When selling puts works best
Specific situations favor put selling. First, the longer until the option expires, the higher the premium you'll receive for selling it. Additionally, the best put-selling instances include:

  • A volatile underlying stock, because the more volatile, the higher the premium you'll be paid when selling a put.
  • A lower-priced stock, because the premium you receive can translate into a significant discount in your stock purchase price (the discount was 15.5% in our Millennium example -- but you can sometimes receive 20% or higher discounts).

Here's an example. Yahoo! (NASDAQ:YHOO) is volatile and, until recently, was priced in the teens. Today it's $30. For argument's sake, say you'd be happy to buy shares for the long haul at $25, but don't want to buy at $30 after this quick advance. You're pretty confident it'll see $25 again.

You could sell January 2006 Yahoo! puts with a $25 strike price right now for $5.60 per contract. Selling 10 would bring $5,600 cash into your account. If you're eventually put the shares at $25, you'd actually be buying the stock at $19.40 after factoring in the premium you received. That's a 22% discount to the option's $25 strike price -- very nice. It's also 35% below current market prices.

If Yahoo! doesn't fall below $25 long enough that you're put the shares, you still keep the $5,600 and don't need to do anything else.

Just know that in all put-selling situations:

  • You must be financially and emotionally ready to buy the stock at the put's strike price, even if the stock falls far below that price.
  • You should only sell puts on stocks that you understand very well and want to own at specific prices or even lower -- in other words, you might run valuation models on a company, determine the price where you'd like to own it (if that price is lower than today's price), and then sell puts and get paid to wait for your price.

In closing, I like selling puts for income and while waiting for a better share price, because you essentially need to be wrong three times before you lose money: 1) The stock needs to fall below your ideal share price before its sold to you; 2) It needs to fall below your ideal share price and below the price you paid factoring in the option premium you received before you start to lose money on it; 3) The stock needs to not recover from that lower price if you're finally to lose any money.

In summary, from the "Foolish Guide to Options":

Selling out-of-the-money puts can be an effective way to purchase shares of stocks you want to buy at prices below the current quotes, while also producing some income in the event your stock doesn't fall to your buy price. Nevertheless, selling puts isn't ideal for every stock. It's best used for those stocks that are both low-priced and offer attractive enough premiums to compensate you adequately for the opportunity cost should you not get the stock you want at your price. In addition, it's important to be prepared to buy the stock in the case that it does fall below your option strike price and the shares are 'put' to you [you should have cash in the account for any needed purchase].

Best wishes...

Jeff Fischer has sold puts on Yahoo! ($20 strike) and Millennium. His $5 and $7.50 Millennium puts are likely to expire worthless to the buyers, leaving him with some good 100% premiums. Jeff also owns Millennium shares. The Fool has a full disclosure policy.