Most investors get caught with their pants down when markets top out and crash. As a result, they have little cash to buy the significant dips and have no cash at all when the market finally bottoms.
Here's a way to raise cash without losing out on potential gains if the market suddenly turns around: Sell your stocks. Use a portion of the proceeds to buy deep in the money calls that are at least several months from expiration date. Buy one call for every hundred shares you sold (provided that every call in the security you sold corresponds to 100 shares).
The idea is to get cash into your account (to decrease volatility, pay the bills, take advantage of the higher yields that dividend paying stocks will pay if they fall some more, etc) while still being able to profit if the market turns around and goes up.
Let's say the cash balance in your portfolio is essentially zero. SPY, the ETF that corresponds to the S&P 500, is trading at $116.37 at the time of writing. Let's say you own 200 shares that you bought at $130 ($26,000) earlier this month. You're freaking out and are thinking about dumping your position at a loss.
You know the drill. As always happens when you sell, the market turns around and goes up. And if you don't sell, it'll probably continue falling. Puts now seem too expensive. You curse yourself for not having the strict discipline to have sold the position much sooner. You don't know what to do but would feel a lot better if you had some cash in your portfolio.
Consider this. The ask on the March 2012 70 strike SPY call is 46.93 at the time of writing. Let's say you sell your 200 shares at $116.37 ($23,274) and buy two of the 70 strike calls ($9,386). The result is you put $13,888 in cash (minus commissions) into your account. That's your cash and you can do whatever you want with it.
You still own an interest in SPY (until expiration date). If SPY keeps falling, you'll continue losing money--about as much as if you still owned the shares. If SPY rises, the calls will go up about as much and you'll gain about as much as you would if you still held on to SPY.
It's possible that SPY will continue falling. Who knows, maybe it'll go to 0. If it does, you'll still have the cash. That's some piece of mind. (Although if SPY is 0, chances are you won't have electricity to check stock prices anyway. Not that you would have time for that, seeing as how you'd be busy fending off roving gangs of hungry people.) Your losses on the calls will decrease as compared to owning the stock as SPY approaches and goes under $70 per share.
This is not some magical way to make money. It's a way to have cash in your portfolio without significantly altering your exposure to the market.
As nothing in this world is free, switching your shares for cash and calls will cost you. In our example above, the cost is 56 cents a share ($112) plus commissions. That's not too bad. We can make it better if we cap your potential gains.
At the time of writing, the 140 strike March 2012 SPY call had a bid of $0.86. If you sell one of these against each one of your long calls (sell two 140 strikes because you bought two 70 strikes), your exchange of SPY shares for cash and calls will be for free. (Actually, you would take in an extra $60 minus commissions.)
If you buy the 70 strike calls and sell the 140 strike calls, you'll have a call spread the gains of which are capped if SPY trades over $140 a share by expiration. That is to say, if SPY turns around and goes up, the most you can make (if you sell the 140 strike calls) in the example is $10 per share (because you bought SPY at $130). The most you can lose through March 2012 is the amount you paid for the calls (in this example $46.93 per call plus commissions plus whatever dividends you miss out on).
If SPY ends up somewhere above $70 per share before expiration and you don't want to buy the stock back, you might want to sell these calls and buy similar ones that expire farther in the future.
There are risks with everything. Holding calls is different from holding stock. Calls on a dividend paying stock, for example, don't pay dividends. Shares don't expire. Options do--and when they do they are worthless. There are many other risks associated with options, particularly deep in the money options. These usually have pretty terrible bid/ask spreads. You may not always get the best price when buying or selling these.
If the strategy above seems interesting, do some research before implementing it.
Disclosure: At the time of writing I owned no securities mentioned in the article.