Options are powerful and flexible tools that can be used by stock investors to reduce risk and enhance returns. However, they’ve gotten a bad rap over the years because they’ve been used improperly by “get rich quick” traders rather than long-term investors.

As with any tool, options can be abused. But the problem is not with the options tool itself, but in its application. In this article, I will explain how options can be used in a conservative and income-producing manner that is appealing for risk-averse investors.

Last week I discussed dollar-cost averaging as a way to lower your downside risk in a volatile market. This is just one method of lowering your cost basis in a falling market.

However, it’s not the only tool in the arsenal.

If you have money to deploy, but you are concerned that stocks are overpriced, you can always put in a “good-til-canceled” limit order and wait. For example, Apple (NSDQ: AAPL) closed last week at $172.39. Maybe you really like Apple, but don’t want to pay more than $150 a share for it. You can put in an order with that stipulation (i.e., a “limit” order). If the price falls to that level — 13% below the current price — your order should execute.

However, if shares never fall to that level, your money is just idle, earning a fraction of a percent in your brokerage’s money market account. There is a better way.

You Have Options

A low-risk alternative is to sell a put. Here is how it works.

A put option obligates the seller to buy 100 shares of a stock if the value is below a defined level at a specified future date. It is the opposite of a call option. If you sell a put, you get paid a premium. It’s basically like selling an insurance policy.

An investor who buys a put is buying the right to sell their shares (in 100 increment lots per contract) at a defined price at which the trade would be executed (the strike price) and a defined date by which the trade would occur (the expiration date).

The person buying the put is either betting the price of the stock will go down, or they are buying insurance against shares they own just in case the price collapses. For example, someone who owns shares of a company trading at $150 a share might buy a put with a strike price of $120 to ensure they can still sell their shares at least at that price.

The person selling the put is creating the potential obligation to buy shares. If you sold the $120 put to the person above, and at expiration shares were trading at $80, then you still have to pay them $120 for their shares. That’s the risk involved, but you are being paid for taking that risk.

Apple at a Discount (or Money for Nothing)

Now, let’s return to the Apple example. Instead of putting in an order and waiting, you can sell a a put with a $150 strike price. There are lots of choices here, but let’s select the $150 put expiring on May 20, 2022 (101 days from now). The current bid on this put is $3.80/share. That means you could generate an instant cash payment of $380 for selling this put.

The implication for you is that if Apple shares trade below $150 between now and expiration, you may be assigned shares at $150. If shares are below $150 at expiration, you will be assigned shares at $150. Because one contract represents 100 shares, you need to have $15,000 in your brokerage set aside for this particular trade.

Note that you can get by with much less for stocks with lower prices. A put sold with a $5 strike price only requires $500 in cash reserved in case of assignment (per contract).

The option probability calculator I use — which is based on historical volatility — estimates a mere 13% chance of assignment for this Apple trade. What does this mean in the case of assignment, and in the case of no assignment?

If you are assigned, instead of paying $150 which you would have done with your good-til-canceled trade, your net price is further reduced by the value of the put premium. In this case, that $3.80 premium reduces the net cost of your purchase to $146.20. Instead of a 13% discount to the current price, you get shares at a 15% discount to the current price.

If you don’t get assigned, then it was just money in your pocket while you waited. The yield you received on the money you risked was 2.5% ($3.80/$150.00) for a 101 day period, which is 9.2% annualized. In this case, when the put expires you can turn around and sell another. If Apple shares never fall to $150, a near double-digit yield while waiting is a nice consolation prize.

Ultimately, there are risks. If Apple shares are $140 at expiration, you will still pay $150 for them. You just have to decide if that risk is acceptable. But this is a great (and conservative) strategy for generating extra income while waiting to get shares at a discount to the current price.

I’ve just described options strategies to enhance income. When it comes to trading options, one of the smartest advisors I know is my colleague Jim Fink.

Jim Fink is chief investment strategist of the elite trading services Options For Income, Velocity Trader, and Jim Fink’s Inner Circle. Jim has agreed to show 150 smart investors how his “paragon” trading system could help them earn 1,000% gains in just 12 months.

We’ve put together a new presentation to explain how it works. Click here to watch.