Getting Out of Net-Stock Jail

What do you call a dot-com employee with a low salary and millions in stock options? Thanks to the recent pullback in tech stocks, you can call him just a dot-com employee with a low salary.

To attract talented employees, "yupstart" Internet companies are offering huge stock option plans in place of big salaries. While this has been tempting in the past, corrections have been humbling workers with millions in options that haven't been cashed in or are still vesting. Internet stocks still have the potential to post huge daily moves that upon first glance, seem to look more like prison bars than a price graph. With the Nasdaq Composite below 4000, anyone involved in a tech stock or options contract should be pretty itchy by now.

Most traders who are smart enough to be dangerous, leveraged up and bought more stock as the market dropped. This has added more money to the falling markets, hence those margin calls of the weeks past. The more the market continues to drop, the more margin calls will be posted to accounts, and the more luxury items will be for sale on eBay (EBAY Quote) and Yahoo! (YHOO Quote) auction sites.

How can someone take such a risky derivative as an option, and use it to his advantage during the correction that is currently upon us? By using it for what options were originally intended for -- insurance.

Let's suppose you did the unspeakable by purchasing Qualcomm (QCOM Quote) on Jan. 3 at 170; and last week the stock was sitting at 130. (The stock has fallen further, but we're going to stick with the 170-130 situation for the purpose of illustration; you can adjust the numbers to wherever you purchased a stock.) Back then, you were down roughly 40 points on the stock and the outlook on the stock may be beyond your holding period. Here's what you could've done to band-aid your stock using options to lower the breakeven without chasing bad money with good.

The first thing a trader has to decide is whether or not the stock in question has a chance of bouncing back. Qualcomm may be a great company and the stock may rebound off its present level. If you believe the stock will bounce, you can then initiate an options repair strategy to help your ailing stock position.

One way to fix this stock problem is by creating a ratio spread that uses call options on the underlying stock. The best way to create this strategy is to buy at-the-money options and sell out-of-the-money options, usually where you originally bought the stock. Remember, you own the stock at 170, so you are looking to sell options at that level. The stock is trading around the 130 mark now, so there is where you will be buying the at-the-money call options.

A ratio-call spread consists of selling more options than buying, usually on a 2:1 ratio. This trade, if done alone, has unlimited risk, yet when applied to a long stock position, looks more like a bull call spread and a covered call . For every 100 shares of stock that you own, buy one at-the-money call option and sell two out-of-the-money call options for even money or a net credit.

In this example, let's use October options because they offer enough premium in the out-of-the-money calls to pay for the at-the-money call purchased. Here's an example:

Qualcomm stock -- bought 100 shares of Qualcomm at 170, currently at 130.

Buy 1 Qualcomm Oct 130 call for 18 3/4

Sell 2 Qualcomm Oct 170 calls for 9 1/2 each (that's 19 combined)

Net credit of 1/4 point.

Now if QCOM were to return to 150 by October, this entire position would be back to breakeven because of the following:

Qualcomm stock -- bought at 170, currently at 150, down 20 points

Qualcomm option trade -- Qualcomm Oct 130 calls worth 20 points intrinsic; Qualcomm Oct 170 calls worth 0 points intrinsic

Qualcomm trade combined has no loss from 150

Another way of looking at this position would be if Qualcomm were to return to 170 by October expiration. The combined trade would now look like this:

Qualcomm stock -- bought at 170, currently at 170, no profit or loss

Qualcomm option trade -- Qualcomm Oct 130 calls worth 40 points intrinsic; Qualcomm Oct 170 calls worth 0 points intrinsic

Qualcomm trade combined now has a 40-point profit.

Imagine if you and a friend took the same trade, and you did the repair strategy when the stock dropped. If the stock went back to breakeven at 170, you would show a profit and your friend would be wiping his brow, thankful that he didn't lose money.

This strategy isn't without its difficulties. Commission can be steep. And, if the stock did catapult to new highs, you're locked into a limited payback, which in this case is the difference between the strikes. Most people that are faced with this situation, are just happy to walk away unscarred from this kind of correction.