RealMoney Readers' Mailbag

The daytrades get a much shorter leash for obvious reasons. Conversely, I try to "get out of the way" of swing trades so the noise doesn't get me. In both scenarios, my stops are set at technical zones where, if hit, the setup I'm trading is no longer valid or I want to "ditch," head back to the sidelines, and wait for a better entry price.

--Alan Farley

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Question: Out of all the stocks that Jim Cramer recommends on RealMoney, what is his selection criteria for Action Alerts Plus?

Hal Bogardus

Answer: These are Jim's top picks, given his one-month minimum holding period. There is no one strategy that Jim uses for picking stocks for the portfolio, but he generally looks for names that appear mispriced in the market.

Jim also tries to identify the sectors that investors will rotate into in coming weeks and months. For example, if the consensus analyst estimates are just too low for a stock or sector, he believes they may outperform the broad S&P 500 index over the next three to six-month period.

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Question: How does an investor go about hedging an equity-only portfolio using long index-ETF put options?

For example: With the S&P 500 at 1400, how does one hedge a $100k portfolio going long SPY put options:

1. 1. how far out in strike price
2.
2. how far out in time

--Siddharth

Answer: One of the simplest and most straightforward ways for limiting risk is to use a married put strategy; that is, the purchase of put options in combination with buying or being long related stock or index product. In a recent article I used the Financial Select Sector SPDRXLF as an example of establishing a married put. For those looking to start bottom-fishing at the financial sector, it might work something like this:

Let's assume you're looking at the XLF, which is currently trading around $30 a share. You ultimately want to own 1,000 shares and plan to buy in three units every $1 down; that is, you buy 333 shares at $30, 333 at $29 and 334 at $28. This would give you an average price of $29.

For downside protection on those buys, you might look at the March $29 put, which currently has a delta of 0.32, but will have a delta of 0.48 if XLF shares trade down to $28. At that point, you'd need about 20 puts to fully hedge your long position.

There are two approaches to getting into this downside protection. One, you could scale into the purchase of puts as you purchase the stock. That is, as you buy each 333-share lot, you buy the appropriate number of put options.

For example, if you bought the first third of the XLF position at $30 a share yesterday morning, to fully hedge it you'd need to buy around nine $28 puts. As the stock traded down to $29 and you bought another 333 shares, you'd need to buy an additional seven puts. Finally, at $28 a share, you'd need to buy a final four contracts to be fully hedged.

I'd rather go in and buy around 15-20 puts right off the bat, when I make the first purchase. Why? I assume I'll buy more stock at lower prices. By getting myself fully hedged from the beginning, the initial cost of the downside protection will be only marginally higher than the total cost of using a scale. Remember, as shares of XLF decline, the price of the puts will go up.

This leads to the important point that by purchasing the full slug of puts from the beginning, you're creating a position that is long gamma -- the position gets longer as shares rise, and actually gets shorter or more bearish as price declines -- meaning you can profit even if the share price of the equity you're involved with keeps declining.

--Steve Smith

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This article was written by a staff member of RealMoney.com.