Using Dispersion: A High Concept at a Low Cost

A Semi-Dispersion Position

The Philadelphia Semiconductor Index and the Semiconductor HOLDRs Trust(SMH) have climbed 33% and 42%, respectively, since their March lows. Recently there has been a flurry of put-buying as investors look to protect those gains.

While this may seem prudent, especially as we head into earnings season; the outright purchase of puts can be quite costly and often an ineffective form of insurance. But using dispersion can establish a low-cost hedge. I'm going to use SMH put options rather than those on the SOX, because SMH options are more liquid and, with the underlying Exchange Traded Fund trading in the $30 range vs. the SOX's $400 price, less expensive.

Some vs. All

The table below illustrates a possible position, prices and values involved in selling five near-the-money SMH puts while simultaneously buying puts on three of the components, Teradyne(TER), KLA-Tencor(KLAC) and Novellus(NVLS).

Prices are based on Tuesday's close.

SMH Dispersion
Stock (Symbol) Price	Option Position	Net Debit/Credit
SemiHolders (SMH) $31.50	Short 5 Aug 32.50 Puts $2	$1000
Teradyne (TER) $19.15	Long 1 Aug 17.50 Put $0.80	(0.80)
Novellus (NVLS) $38.40	Long 1 Aug 37.50 Put $2.10	(210)
KLA-Tencor (KLAC) $50.20	Long 1 Aug $50 Call $2.30	(230)
Net		480
Source: TSC Research

The Payoff

The sector is basically pricing in positive earnings and an optimistic second-half outlook. If this holds true, the group as a whole should rise, taking the short SMH puts out of the money, rendering them worthless. The position would most likely be a scratch or even yield a moderate profit of $480, or the net credit premium. Any existing long shares of underlying stocks will be poised to rack up further gains.

Given the stock basket dynamics and the fact that the three stocks in the example represent just 5.8% of SMH's composition, a decline by one of the stocks should translate into a smaller percentage move in the basket at large. There's an opportunity for profit if an individual issue declines by a greater magnitude than SMH itself. This could occur if one issues a warning or has bad company-specific news instead of a problem plaguing the entire sector.

A danger for the position would be if one of the three stocks with the largest weighting, Intel(INTC), Texas Instruments (TXN) or Applied Materials (AMAT), which together represent 47% of SMH, were to stumble, causing the ETF to drop significantly more than one of our three protected issues.

Construct a position that best matches your existing portfolio and most accurately reflects your market opinion and outlook. You may gain more downside protection by buying puts on a different or larger group of individual issues.

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