My most recent article discussed developing an overall portfolio investment strategy. Many readers wanted more detail on the processes underlying the use of options as a main component of my own portfolio strategy. This is a somewhat complex and certainly lengthy undertaking, so I will spread it out over several articles.

Every option strategy must consider both the theoretical result and the "most likely" result. So let me start with the theory of hedging. Hedging theory is pretty simple. Find two stocks with similar characteristics, short the weaker one and go long the stronger one. Another popular choice is to short an index and go long the component stock, or stocks, that look to outperform the index. Your profit (or loss) is the differential in their returns and you have, presumably, reduced your risk to capital.

The theory is easy to comprehend. It is not so easy to actually pick the stronger/weaker. But what if you didn't have to pick a stronger/weaker? What if one stock had both strong and weak sides and you simply played these characteristics against each other?

In a previous article I detailed the CBOE .PUT Index. This index shows the results of selling near month at the money puts on the S+P 500. Here's a chart that compares the .PUT Index with owning SPDR S+P 500 Index ETF (NYSEARCA:SPY) over five years.

Wow. Selling puts would have gained over 20% and buying SPY would have lost nearly 10%. One adjustment is necessary, that is to add in the dividends on SPY. Assuming they averaged about 2% per year, then that brings SPY to a slight (1%-3%) gain. But, SPY still trails selling puts by 20%. So, in theory, one could have actually sold near term ATM puts on SPY and simultaneously shorted SPY and made 20% with no risk to capital.

Now, I could show more comparison charts, covering different time frames. Instead, I recommend and leave it up to each reader to look at them on their own. Let me, instead, summarize my discoveries.

- Over time, selling near term ATM puts outperforms owning SPY.
- Selling puts substantially outperforms when SPY is flat or in a tight trading range.
- Selling puts substantially outperforms when the market is falling.
- Selling puts under-performs, somewhat, when the market rises. The faster the market rises, the more it under-performs.
- I have found no index that compares selling puts to outright ownership on other than the S&P 500. It is too daunting a task for me to try and construct one myself. But, experience (and my "gut") tells me that a long/short put strategy will NOT work with a high-Beta stock.
- So, given this theoretical outcome, I can construct an overall portfolio strategy that works as follows:
- Sell puts on SPY and go "short" SPY. My next article will detail how I go short.
- Be more aggressive when the market is in a trading range or more likely to go down. The .PUT index used ATM puts, perhaps selling puts out-of-the-money, trying to improve on the results.
- Sell in-the-money puts at times that the market is likely to go up. Again, if I get it right, I improve the result.
- Don't use this long/short strategy on high-Beta stocks. Hence, I go long, un-hedged Apple (NASDAQ:AAPL) and EWZ and FXI.

So, there it is, the theory behind the portfolio construction. In the next article I will detail how I implement this strategy and try to bring it to real life. For those that are interested, here's a link to an excellent article that fully explains the .PUT index.

**Disclosure: **I am long AAPL. I buy and sell puts on SPY, FXI, AAPL and EWZ.