Don't Call the Top, Sell the Call

The recent rally has inflicted serious pain on those caught short. But for those of us who still have a little powder and nerve left in our arsenal, this moonshot provides another opportunity to trade from the short side. But we need to be careful.

Just as we know that trying to "catch a falling knife" in a declining market is a dangerous game, one can get equally bloodied in attempting to "lasso a rocket at its trajectory inflection point" during a rising market. OK, so my newly coined expression doesn't exactly roll off the lips ... but you get the idea.

At some point gravity kicks in, and stocks can't rise in a straight line forever. But given the market's current momentum, with many stocks hitting 52-week highs and little resistance in sight, choosing where to short shares is a difficult and potentially costly proposition. Selling call options, however, lets you establish a moderately bearish position without pinpointing the top.

Promising to Sell

When an investor shorts call options, he or she is selling a promise to deliver shares at the strike price before the expiration date. Unlike a covered call or buy-write, in which one owns the underlying security as an offset to the short call, this position is referred to as being a "naked" call seller.

The major drawback of shorting calls vs. shorting shares of the underlying is that while both present potentially unlimited losses if the stock price rises to infinity, the profit potential of the call is limited to its sale price. Assume XYZ Corp. shares are trading at $50 and you sell five July $55 calls for 80 cents each (remember: each call represents 100 shares, so the multiplier is 100 -- this provides leverage). If XYZ trades infinitely higher, you can lose an infinite amount of money. Of course, the margin requirement will prevent a position from running too far away. Short calls are subject to similar margin and maintenance margins of a straight short sale. But the profit in this case is limited to just $400 -- equal to the net sale price of the call options.