Protect Those Bets on the Short Side

Editor's note: This column was originally published March 11.

The current wisdom says that once war with Iraq starts and it becomes apparent the U.S. has things well in hand, stocks are poised to rally sharply, possibly even marking the end of the bear market and the beginning of a new bull. This view has many short-sellers, now in the fourth year of their post-bubble feast, not wanting to overstay their welcome. They're getting nervous and quick to cover. And I believe that after so many months of anticipation, the commencement of military action will bring an initial rally.

But until proven otherwise, we're still in a bear market for stocks. So it seems to make sense to me that rather than fight the tape from the long side, investors should keep an eye out for opportunities to make money from the short side.

Short Until Proven Long

While it's definitely a little late in the game to begin a wholesale short-selling campaign, looking at ways to establish and maintain some selective short positions might be useful.

I and others have described how recent activity in the options market has been dominated by covered-call writing as investors look to generate income while preserving the potential for upside gains. If longs can try to improve their cost basis by selling options, so can the shorts.

In this column I'm going to describe the mirror image of covered calls: selling puts against a short stock position. What's better is the fact that puts generally -- and that's the case now -- sport slightly higher premiums than calls, providing an improved rate of return.