"Baby puts" refer to put options that are far out of the money, and therefore trade cheaply. Investors will sell these baby puts on stocks that they are comfortable purchasing at a specific price, which will be the strike price of the put they are selling. Typically, this is the price that builds in a margin of safety to their estimate of the stock's fair value.
For example, say an investor would be happy to purchase Coca-Cola (KO) for $35 per share, but the stock is trading at $45. It's currently January, and the investor notices that the May $35 put options are trading for $1. The investor decides to sell (write) the May $35 put options for $1. This means the investor collects $1 for selling the right to someone else to sell the investor the stock for $35 anytime before the option's May expiration date. So, if Coca-Cola stock doesn't fall below $35 by the May expiration, the investor pockets the $1. However, if the stock falls below $35 before May, the investor will probably be required to purchase Coca-Cola stock for $35, because the person to whom he or she sold the put option will exercise his or her right to sell the stock for $35.
Value investors might be willing to partake in this strategy because they decided in advance that $35 was a good price to purchase Coca-Cola stock. And, if the stock doesn't fall below $35, they get to collect $1 (by selling the baby put) as they wait for Coke's stock to trade cheaper.
This strategy is not without some fairly large risks. If the investor doesn't have enough cash in his or her account to purchase the stock, the investor's broker may require additional funds be deposited. We'd recommend considering this strategy only if an investor has plenty of cash on hand. Also, a fresh piece of news could surface (between the time the investor sells the put and the put expires) that might change the investor's opinion of the fair value of the stock.
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