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Using short puts as an investment tool

Chris McKhann (chris.mckhann@optionmonster.com)

The option world can be complex and confusing. The names of strategies alone-- butterflies , collars , straddles , strangles --can make one's head spin. Throw in all those volatility measures , and it's just too much for many investors.

Not surprisingly, many stock traders don't have any interest in delving into the option world. But while they may never master the iron condor , they would do well to learn one strategy.  

Selling puts is one relatively simple trade that packs a potential profit boost for those willing to take just a bit of time to learn it. Many people believe that put selling is a dangerous strategy, and it can be if one doesn't understand the parameters. This is especially true when combined with leverage, which has driven plenty of people out of business.

But selling puts with the intent to buy its underlying shares is very different. Selling a near-term at or in-the-money put in a stock that you want to own gives you the opportunity to collect risk premium while purchasing the shares.

We saw one such example recently in CA Technologies . A trader sold the February 26 puts for $0.90 while the stock was trading at $25.41. Given that these puts are in the money, the seller could be assigned at any time in the next three weeks until that February expiration. If that occurs, the trader will buy 100 shares for each put sold, but the effective price would be $25.10 when the credit from the sale is included.

The put seller is better off than simply buying the stock or even out-of-the-money calls because of that $0.90 downside cushion--as long as he or she sells the appropriate number of puts and doesn't use leverage.

The real risk is that the stock moves higher and the trader misses out on the upside. In this case, the stock would have to run above $26.90. But even then, the position can still make a profit, just not as much.

The CBOE has a PutWrite Index based on the S&P 500 puts. The PUT index has outperformed the S&P 500 and the CBOE S&P BuyWrite Index strategy in the long term, and it did so with lower volatility.

Selling in-the-money puts increases the probability of getting assigned and ending up owning the stock that you want. Some traders are looking to do the same thing but use out-of-the-money puts , looking to get paid for waiting and buying on a pullback.

As inspiration for those who are on the fence, there is an interesting precedent.

Warren Buffett has said that derivatives such as options are "weapons of mass destruction," but the Oracle of Omaha is arguably the largest individual option trader in the world. His strategy? Selling puts .

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