Options: Your Port in Rough Waters

This column was originally published on May 17 at 4:14 p.m. EDT.

"Is it safe?"
"Tell me what the 'it' refers to."
"Is it safe?"
"Yes, it's safe, it's very safe, it's so safe you wouldn't believe it."

-- Dustin Hoffman, trying to find the right answer for Laurence Olivier in Marathon Man

After a great rush at the end of 2004 in which the S&P 500 galloped some 15% higher in the final three months of the year, investors are once again facing the choppy market. The S&P hit a three-year high in late March as earnings, economic data and a measured and watchful monetary policy suggested a period of sustainable earnings growth in a controlled inflationary environment.

But then things turned bad, thanks to a few off-key reports. The S&P has tumbled some 5.9% since late March and has seen 30-day intraday volatility reach a 14-month high.

The stock market's schizoid performance over the last few months has created a quandary for investors: Choose between chasing stocks at ever-higher levels as many did earlier this year, or step into a downdraft like the one that was delivered last Friday. Nervousness and questions abound: When and where is it safe to buy? Should we just hide on the sidelines until the all-clear signal comes? Basically, it's the age-old tug of war between fear and greed.

Create Your Own Dip in the Road

I propose that a good third alternative for lessening both the risk and pain is to consider selling puts as a means of buying stocks at a discount to the current market price without having to wait for the underlying stock price to dip. As we know, selling puts short creates a moderately bullish position in which the maximum profit, no matter how high the price of the underlying shares rise, is limited to the sale price of the put. And if the underlying price falls below the put's strike price, it also reduces the effective purchase price if the short put is assigned.

The benefit of selling puts on stocks is that it establishes a predetermined purchase level. This means you don't have to worry about second-guessing or backpedaling with "cancel if close" orders when faced with steep and scary selloffs. If you did your homework and wanted to buy shares at a certain price, selling puts is a great way to let the market come to your price. If the stock does not sell off, then at least the puts generate some marginal income through the premium collected.