The Finance Professor: Investments for Grads

I use our margin capacity to sell puts on stocks at price points that I'm willing to buy and hold long term. If the price doesn't come down, I keep the premium, and if it hits the strike price, I'm happy to buy the stock.

I'm relatively new to managing our portfolio, having been the typical "buy and forget" investor. I don't see many people writing or talking about this type of strategy. What am I missing?

I've also used our margin capacity for short-term trades and account for the interest in the net per trade. -- John Z.

Selling puts is an interesting way of trying to get long exposure to a stock by using margin ("Understanding Leverage"). However, it is more complex than meets the eye. I teach an entire course in derivatives at Seton Hall's Stillman School of Business and will cover options in "The Finance Professor" at a later time. From a risk perspective, selling puts is identical to buying stocks and selling covered calls. Thus, while selling puts will give you leveraged and apparent cheaper exposure to a stock, it will also require a margin deposit and your gains will be capped out unless you are first to put the stock ("Getting Started With Options").

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The psychology of the markets and one's decision-making with respect to risk is quite interesting. When markets are going up, investors should try to control greed and fear, yet maintain an appropriate investment strategy.

Can you offer some advice on protecting gains in up markets? -- Fred B.

When a stock is doing really well, here is what I do and what I suggest for you. If you initially bought a stock based on an event, such as a new product introduction or a court ruling, sell it right away or place a stop , so you can lock in gains but still have some upside.

However, if you bought a stock based on fundamental research, then you should set a price target at the inception of your position ("Ask TheStreet: Target Practice"). When the stock hits your target, use the opportunity to re-evaluate the stock.

How? First, given the most up-to-date fundamental data, look ahead to one year from now and estimate a price target that you might see down the road. If you determine that no higher target price can be obtained, then sell your holdings. If you raise your target, then consider selling a portion of the position to lock in gains or set a stop for all or part of your position. If you're a more experienced investor, selling covered calls could be worked into this strategy as well ("Getting Started With Options").