How to Buy Cheap Stocks Even Cheaper

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With all the choppiness in the markets lately, it's hard to know whether stocks are really bargains. Even a beaten-down stock can fall further -- and no one wants to try to catch a falling knife only to see the share price continue to drop after buying in. Meanwhile, some stocks have held up very well despite market volatility.

But even if you're disciplined enough to stay patient and wait for the right price to invest in stocks, you can still find yourself waiting for a very long time. But if you can pick a price that you're 100% sure you'd want to pay for shares, then there's a method you can use involving options that can help you earn some extra cash while you wait for the stock to hit your target.

Easy money
Yesterday, I looked at the covered call strategy and how it can boost your income on stocks you already own. But if you don't already own shares, then covered calls won't work for you.

That doesn't mean you're out of luck, though. By selling put options, you can pick a price you want to pay for shares. If the stock drops enough before the option expires, then you'll end up with the shares you want at the price you asked for. And regardless of whether the options get exercised, the money you received for selling the put option is yours to keep.

The basics are simple: Selling a put option contract commits you to buy 100 shares of stock at the specified price if the put buyer exercises the option. The buyer pays you an upfront premium for the option. Most of the time, if shares stay above the exercise price of the option, then the put buyer will let the option expire unused, and you just pocket the premium. But if shares fall below that exercise price, then the owner of the option will exercise it, selling shares to you for more than the future-prevailing market price.

What's the right stock?
In thinking about put options, it's helpful to switch positions and consider them from the buyer's perspective. Put buyers typically want to protect themselves from big drops in the stocks they own. But if you want to buy shares at bargain prices, you may actually want those big drops to happen.

So the right stocks to sell put options on are those that you'd like to buy but at a somewhat lower price. Once you pick those stocks, figure out what price you'd be willing to pay, and then write put options with an exercise price that matches up with your desired purchase price.

One way to find promising stocks is through our Motley Fool CAPS service. For example, using the CAPS screener, I found top-rated five-star stocks that trade at reasonably cheap valuations but are still within 10% of their 52-week highs. Here are some of the largest stocks that pass that simple test, along with how much you'd receive for selling a put option at a price around 20% lower than where the stock currently trades:

Stock

Current Price

Put Option

Option Price

(NYS: ABT) $54.54May 2012 $450.85
(NYS: EXC) $43.72April 2012 $370.47
(NYS: JNJ) $63.49April 2012 $500.51
(NYS: MCD) $96.01June 2012 $751.16
(NYS: NSC) $74.86June 2012 $602.45
(NYS: PM) $75.58June 2012 $601.43
(NYS: SDRL) $35.85April 2012 $291.30

Source: Yahoo! Finance. Prices as of Dec. 6 close.

If you're willing to lock yourself into buying these stocks at a 20% discount anytime between now and next spring, you can earn between 1% and 4% of each stock's current price. If stocks stay above the exercise price of the put option, then you just keep that 1% to 4% for yourself. If the stock drops, you'll get the shares you want, along with the premium as extra income.

What you give up
The downside of writing put options is that you have to commit to buy the shares no matter what happens. Whether it's an unexpected collapse in the overall market or a company-specific item, you'll be stuck with the shares even if you'd prefer to change your mind. As long as you only use the put-option strategy on stocks you definitely want to own, though, then everything should turn out fine.

If you like the idea of options but aren't comfortable with your skill level on them, take a look at the Fool's "Options University." It's absolutely free but only available for a limited time, so just enter your email address in the box to learn more about how options can fit into your portfolio.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time this article was published Fool contributor Dan Caplinger can't argue with cheap investments. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Johnson & Johnson, Abbott Labs, and Philip Morris International. Motley Fool newsletter services have recommended buying shares of Exelon, Johnson & Johnson, Philip Morris International, Abbott Labs, and McDonald's, as well as writing a covered strangle position in Exelon and creating a diagonal call position in Johnson & Johnson. 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 loves to keep its options open.

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