Market News

October 22, 2010  Fri 8:35 AM CT

Put selling is often considered one of the riskiest ways to play options, but they can be a useful tool even in some relatively conservative strategies.

The horror stories we hear often involve traders blowing up with short puts, especially when they're used to trade volatility with significant leverage. (Think Victor Niederhoffer.)

But those traders aren't selling puts to buy stocks, which is what some portfolio managers are doing now.

Dagny Maidman is one such manager. Overseeing $1.1 billion for Credit Suisse's Private Bank, she deals with a lot of CEOs who have most of their net worth in cash and other fixed-income securities. Her job, of course, is to protect capital, but also to get her clients into investments that will do a better job of growing wealth and keeping up with inflation.

Given the uncertainties facing the markets, her clients are understandably wary of equities right now. But Maidman has come up with an interesting solution that can apply to all longer-term investors, not only the wealthy: selling cash-secured puts as a way to purchase stocks below market prices.

This strategy carries less risk than buying stocks directly, something that is frequently overlooked because of the risk perception surrounding short puts. (See our Education section)

MRKMaidman recommends that her clients sell out-of-the money puts on high-quality individual equities. This way, they get the income now from the put sales and, if those stocks fall in value, they get to buy them effectively at a discount.

In a recent interview on CNBC's "Strategy Session," Maidman described the options "skew," saying that "the price of puts relative to calls" is very high at current levels. "The price of insurance in these stocks is higher, and so we want to sell that insurance," she said.

Maidman has identified options that produce 7 percent to 11 percent annualized income on stocks that she would like her clients to own. So if and when the stocks do pull back, the investors are essentially reallocating from cash and fixed-income into those names. 

Merck provides one example. The pharmaceutical stock seems to fit her qualifications for equities she is looking for, including a solid dividend yield and free cash flow.

At the time of the interview MRK was trading at $36.90, near its highs of the last six months. Selling the November 34 puts for $0.40 gave a yearly yield of about 9 percent. Looking at the delta, there was an 81 percent probability that MRK will be above that at expiration.

Now clearly it is necessary to overlay a bit of option and volatility analysis to this strategy to ensure that you are getting the best bang for the buck. While the implied volatility of MRK was at 24 percent, near the lows, it was much higher than the 30-day historical volatility of the last three months.

Granted, with the equity markets at relatively inflated levels and volatility relatively low, this might not be the best time to use this strategy. But when stocks do inevitably sell off and volatility does spike again, this strategy becomes even more attractive for longer-term investors.

(A version of this article appeared in optionMONSTER's Open Order newsletter of Oct. 6. Chart courtesy of tradeMONSTER.)

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