Don't Call the Top, Sell the Call

Giving Up Gains but Gaining a Cushion

A beneficial tradeoff of limiting your profit potential is that shorting calls can substantially raise your net sales price. In our example, the effective sale price is $55.80, $5.80 or 11.6% higher than the current market price of $50.

"One of the major misconceptions involved in selling naked options is the risk, when in fact it is no greater than being outright short the underlying," says Mike Schwartz, chief option strategist at Fahnestock's Oppenheimer division. Schwartz's statement echoes a general rule of thumb in options trading: Don't be naked options with more than 90 days remaining until expiration. "This allows one to take advantage of the fact that options are an eroding asset," he says. An option's time decay, as defined by theta, accelerates as the expiration date approaches.

Winning by Not Losing

This means that even if the shares of the underlying simply stall or rise slowly, the naked-call seller can still realize a maximum profit. The table below provides the profit and loss profile for our hypothetical example.

Shorting 500 Shares of XYZ at $50 vs. Shorting 5 July $55 calls P/L Based on price of XYZ on July 18 expiration
Position	$45	$50	$55	$60
Short 500 XYZ at $50	$2,500	0	($2500)	($5000)
Short five XYZ July $55 calls at 80 cents each	$400	$400	$400	($4600)

As you can see, the risk/reward for extreme moves would favor an outright shorting of the underlying shares should there be a precipitous decline. The naked calls provide a nice means of generating a moderate profit even if XYZ climbs higher than the initial entry point.

Shorting Biotech

While shorting biotechnology stocks has proven hazardous to your portfolio's health recently, I think this group is a prime candidate for employing a short call strategy. Using the Biotech HOLDRs(BBH) Exchange Traded Fund, or ETF, as a proxy for the group, the sector has gained some 38% over the past three months.

BBH Has Had Healthy Run But now it needs to rest?

But I think the recent reversal off resistance at the $130 level will mute upside momentum in the near term. On Tuesday afternoon, with BBH trading at $123, one could sell the July 130 call for $3. This gives an implied sale price of $133, or 8.1% higher than the current market price. The maximum profit of $300 per call contract shorted will be realized should BBH settle at any price below the $130 strike price on the July 18 expiration.

While many stocks might seem to be hitting overbought levels, the market always seems to have a way of pushing a little further and longer than appears rational. This is where having the price cushion created by selling options can be invaluable. But remember: Shorting calls naked should be used as a relatively short-term trading tool rather than establishing a fundamentally long-term bearish position.

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