Consider Selling Puts in a Toppish Market

The market is toppish at this point.  Anyway you slice it, 40% off the bottom in just a few months is a hell of a move.  It almost rivals the speed at which it raced for the bottom.  I've made a bearish move and I'm also looking to take a little profit on some items that have run hard.  Besides that, there isn't a whole lot to do and I'm quite nervous about putting fresh money into the markets.  There is still an option, pun sort of intended.  Short puts.  I've used this strategy in the past with some success and some pain, but I ended up owning indexes and stocks that I wanted at a discount.  The key for me is to find a stock or index that you'd like to own and determine your 'steal' price.  Sell a put or two below that price.  There are three possible outcomes.  The stock rises, the options expire worthless and you keep the premium.  The stock stalls in a range, above your strike, option expires worthless, you keep the premium (and write more next month).  And finally, the stock moves south, you're assigned and you get a holding you wanted at a discount.

There are some pitfalls, of course, but the worst case situation is that you own the stock.  So if you understand the risk of owning stock (i.e. it can go to 0), you have defined your risk.  There is a subtle pitfall in the way of leverage.  Let's say I sell 10 puts at a 10 strike with a premium of $10 apiece for a $100 credit.  I'm pretty well on the hook for 1,000 shares of stock.  If XYZ falls below $10 on expiration day, I'd better have $10,000 free in my account to accept the assignment.  It is important to understand the aspects of levrage here.

Practice makes perfect.  Don't like the idea of being a cash covered short, start off with a vertical spread.  Back to the $10 strike example, you sold your 10 puts for $100 credit.  What if for $5 per option you could limit your downside to $2,500 instead of $10,000?  You would buy 10 puts at the $7.50 strike.  Now your total risk is the distance between the strikes, minus the credit, for a total risk of $2,450.  That's a pretty expensive hedge, but just serves as an example.

I also prefer vertical spreads on items I don't want to necessarily own, but feel are in a very favorable place for a trade.