With the S&P 500 posting new highs, it’s become difficult to find stocks with decent yields as well as ones that aren’t priced for perfection. Until I found this solution…

Stocks are on fire. With nearly three-quarters of the S&P 500 stocks posting new highs in the past few months, it’s become increasingly difficult to find stocks with decent yields as well as ones that aren’t priced for perfection.

The solution? 

By using a conservative strategy that involves selling put options contracts, you can in effect get paid to buy stocks at a discount.

#-ad_banner-#Here’s how it works.

Let’s say you want to add computer maker Hewlett-Packard (NYSE: HPQ) to your portfolio. However, the price you’re willing to pay is closer to the recent low of $23.43 a share than to the current $25.73 level.

You could place a limit buy order for HPQ at $23 a share. Maybe Hewlett-Packard will drop to your buy price sometime soon, or maybe it won’t.

Maybe you’ll find some place to park your cash in the meantime where it will return more than a couple percentage points in interest, or maybe you won’t.

That is, unless you’re using a put-selling game plan.

Put options give investors the right — but not the obligation — to sell a stock at a specified price before a specified date.

Using the example above, you could sell a HPQ September $23 put option contract at the going rate for that option (about 60 cents a share at current levels). The instant income, or “premium,” that you receive from writing the option — in this case, about $60 per contract — is yours to keep no matter what. (An option contract controls 100 shares.)

When you sell a put, you are obligated to purchase that stock from the put buyer if shares fall to the specified price (the option’s “strike price“) — in this case, $23.00 per share — by the expiration date, in this case Sept. 21. But remember: that’s the discounted price you wanted to pay for shares of HPQ in the first place. And because you already pocketed a premium for selling the put, your cost basis is actually $22.40 ($23 (strike price) – $0.60 (premium per share)).

And if HPQ doesn’t fall to the strike price before the specified date? You no longer are obligated to purchase the stock, but you keep the premium.

This is the same strategy Warren Buffett used to collect a cool $7.5 million in the early 1990s on put options that expired on shares of Coca-Cola (NYSE: KO), which today is the Oracle’s biggest single holding. 

And it’s the strategy Amber Hestla-Barnhart, Profitable Trading’s income and options expert, uses every week in her Income Trader advisory. Her advisory is designed to help readers generate income from the options market. Amazingly, every single trade that Amber has closed in Income Trader has been a winner — that’s one winning income trade a week since February 6.

For more from Amber, read on…

Bob: With the market at all-time highs, what are you recommending now?

Amber: I recently advised my readers to put together a stock wish list — stocks they would like to own, but at lower price.

Your wish list might include dividend stocks that have moved higher, lowering their yield, or “Forever Stocks” trading above their “buy under” price.

Next, determine the price you would like to pay for the shares. If the current price is below the price you’re willing to pay, the stock is a buy. If the current price is above your buy price, selling a put using the buy price as the strike price could be the best action to take.

By determining your buy price in advance based on what you believe the stock is worth, you avoid making an emotional decision in a fast-moving market. And by selling puts when prices are high, investors are forced into action when stocks are cheap, ensuring you’ll get to buy shares at a price you considered to be fair, or even a bargain.

If the stock does not fall below the put’s exercise price, you will be able to sell another option and generate more income. This will help you earn income on cash awaiting investment and ensure that you buy a stock when you think the price is right.

Bob: If a reader wants to sell a put, how do they enter the order?

Amber: If it’s their first time selling puts, they might need to call their broker.

Almost all brokers allow options trading, but there’s a catch in that you might need to request approval first. This can be done with a form that asks questions about your income and investment experience. Some brokers also require minimum account sizes.

Assuming their account is set up to sell puts, the next step is to find the right option. Options quotes can seem confusing at first glance, but are actually fairly easy to understand.

Let’s use the HPQ puts with a $23 strike price that expire in September as an example. As I mentioned above, that’s an option that expires in September with a $23 strike price. Here’s how this option is quoted on Yahoo Finance:

All options quotes start with the ticker symbol of the stock or ETF, which is “HPQ” in this case. That is followed by the expiration date, which is Sept. 21, 2013, and is in year/month/day format (130921). Options always expire on a Saturday, but all trading in the option must be done by the close of the third Friday of the month.

The “P” in this case shows that the quote is for a put. If the option is a call, that letter will be a “C.” The remainder of the quote is simply the strike price, $23, with a number of extra zeros added so the format can be used with stocks of any price.

This same quote could also be written HPQ Sept13 23 P. This quote has the same information as the one above… the underlying stock ticker, the contract month and year (September 2013), the strike price, and “P” or “C” for put or call.

Once you’ve found the correct quote, the last step is to “sell to open” to enter the trade. Similar to opening a stock position, you can enter a limit order or market order. I generally recommend selling options with limit orders, to ensure you sell at the price you want

Bob: How have you managed to come up with nothing but winners in Income Trader so far? What do you look for when deciding on a recommendation?

Amber: My primary goal with each trade is to protect my readers’ capital, and my secondary objective is to generate income from that capital by selling options. That’s my starting point each and every week, and it has served readers well, so I stick with it.

The most important step when selling puts is to choose the right stock. That means only selling puts on stocks you don’t mind owning.

For me, that generally means undervalued stocks. One of my favorite tools for determining value is the price/earnings-to-growth (PEG) ratio, a derivative of the price-to-earnings (P/E) ratio that takes into account future growth.

To find the PEG ratio, divide the P/E ratio by the earnings growth rate. This ratio finds promising value stocks without ignoring growth stocks. Companies that are growing earnings faster than average deserve higher-than-average P/E ratios, and the PEG ratio accounts for that. There are other value metrics I analyze, but the PEG ratio is where I often start my search for great stocks.

After finding undervalued stocks, I search for puts that allow me to collect income or buy stocks at 10% or more below fair value. In most cases, I won’t have to buy shares, and I book the premium as pure profit. If I am obligated to buy the shares, then I’ll own a great company at a dirt-cheap price.

As for the timeframe, the options I sell generally expire in one to two months, which makes the investments liquid, meaning my money is not tied up for long periods of time. Depending on the market, I might sell longer-term options, but most of my income plays in Income Trader are short term.

Note: Last week we surveyed Amber’s readers to get their thoughts on Income Trader. One reader has used Amber’s recommendations to generate $19,500 in income so far. And until 11:59 p.m. today, you can sign up to follow Amber’s recommendations at a 50% discount. Click here for the details.