Two Option Strategies for Value Investors

This was originally published on RealMoney on May 1, 2008 at 2:59 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

One of the most amazing things I have noticed in my 20 years around the financial markets is how dogmatic the players are.

Value guys think growth guys are crazy. Growth guys think value investors are missing the point of it all. Stock investors eschew options and other forms of derivatives . Option traders think traditional stock investors are more than a little stodgy. Everybody agrees that the futures traders are insane gunslingers.

For many years I was as bad as everyone else, sticking rigidly to the principles of value and distressed-securities investing as I had learned them over the years. About eight years ago, through the generosity of a certain barefoot New York speculator, I was introduced to a new way of looking at the markets. I could add certain instruments and techniques to my basic investing style and gain incremental returns.

Chief among these tools was the use of options to enhance portfolio returns. Although most value investors eschew options altogether, I have found them extremely useful as a way to enter and exit positions while collecting premiums. Truth be told, options are tailor-made for a value style. You can sell overpriced options on underpriced stocks and add several percentage points to your returns.

Two Ways to Play

There are two basic option strategies that, in particular, have a great appeal to me. One is the selling of cash-secured puts on stocks I want to own at lower prices. Cash-securing a put simply means that I am putting up enough cash to pay in full for any shares that I might be forced to buy.

So, for example, if I am selling 10 puts on a stock at a $10 strike price , I will put up the full $10,000 rather than just the exchange minimum margin. When you do this, selling puts, far from being the high-risk strategy that many brokerage firms' compliance and margin clerks would lead you to believe, has the exact same risk profile as selling a covered call. If the stock goes below the strike price, you have the market risk of the position. If it goes up, you keep the premium for small gain. It is exactly the same.