Ask TheStreet: Put Patrol

"If the shares really take off, you'll have left a lot of money on the table. Therefore, selling puts might not be the best strategy for stocks that have the potential to shoot higher in a short time frame," says Smith.

But let's assume XYZ shares remain at $47 and the August put expires worthless. What did this trade return? An often-used calculation is dividing the premium collected by the share price -- in this case that would produce a yield of 3.2% over the seven weeks, or about 23% on an annualized basis.

"Selling puts creates a moderately bullish position in which the maximum profit, no matter how high the price of the underlying shares rise, is limited to the sale price of the put," says Smith. "And if the underlying price falls below the put's strike price, it also reduces the effective purchase price if the short put is assigned."

Smith also points out that while covered calls are often touted as a conservative strategy and a great way to generate income, selling puts has the same risk/reward profile as a covered call. The only difference is in the margin requirements.

"If you already own stock you can sell calls against it without additional capital as the long stock is collateral against the short calls," says Smith. "But if you are establishing a new position, selling puts is actually lower-requirement and therefore will provide a better return on investment."

What exactly do stock commentators mean by "fair value" and how is it determined? Thanks, E.M.

The "fair value" term that is tossed around in the media refers to the relationship between the futures contract on a market index, like the Dow or S&P, and the actual value of the index. You may hear it on CNBC before the bell to give an indication as to how the market will open: If the futures are above fair value then traders are betting the market index will rise. If the futures are below fair value then they think the market will drop -- at least out of the box.

As to determining fair value, a professor at Vanderbilt University named Hans Stoll derived a formula for calculating it. According to HL Camp & Co., Stoll's formula boils down to the following: "Fair Value is the value of S&P 500 Index, plus the interest I pay my broker to buy all of the stocks in it, minus all of the dividend checks I get from those stocks."

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