Hi Steve,
I would like your feedback on what you believe is the best way to protect yourself when selling a combination on the Philadelphia Semiconductor index (SOX). As an example, I sold the November 390 calls at $17 credit and the November 350 puts for $10 credit for a total credit of $27. My problem always seems to be having or putting the proper protection in place when a side goes against me. I was then at times trying to roll out the position that goes against me to the next month to collect more premium, but that may not work if the index continues in that direction. Any suggestions on how to fine-tune this strategy?
-- Larry

Just to make sure we are all on the same page here, the position described above -- selling (or buying) both puts and calls with different strike prices -- is defined as a strangle. The term "combination" is used somewhat loosely, but it usually involves a long call and short put -- or short call and long put -- with different strike prices.

A short strangle carries unlimited risk, making it one of the most dangerous option strategies. Typically, a strangle starts as a neutral position that profits if volatility contracts and price remains within the range defined by the strikes.

My first suggestion is that you make sure you have a clear reason and objective for establishing such a position. It's important to distinguish between a pure volatility play, which is basically a short-term trade, and shorting premium on the belief that the market will remain within a certain price range for an extended period of time.

Because a short strangle gets longer as price declines and shorter as price increases, the position is constantly on the defensive, which, as the reader says, "leads to putting in protection when a side goes against" you. This means you are essentially always buying high and selling low. If you are constantly incurring small losses, it will be very difficult to realize a profit, as the benefits of time decay will be easily negated.

What's worse is that even as the profit potential diminishes with each adjustment, the risk remains unlimited. Indeed, by rolling out to a later month, that merely moves you to the flat part of the time decay slope, extending the life of the risk you carry and delaying rewards. An ongoing naked short strangle is a ticking time bomb. Eventually some event will occur and blow you out of the water.

If you think the market or a stock will remain range-bound and you want to profit from collecting premium, you should establish your protection and limit your risk from the beginning. A simple solution would be to simultaneously sell a bearish call spread and sell a bullish put spread. Or consider using other market-neutral strategies such as a butterfly or a condor, which have smaller profit potential but a defined and limited risk.

Great explanation on the call strategy. Just one question: What would you do if the stock in your UTStarcom (UTSI) - Get Report example went to $23, where you wanted to sell out of the long side of your position? Would you sell a put so you're not short the calls? If so, would you sell the same month/strike puts?
Thanks in advance,
Todd

If it's close to expiration, you can just stand pat and let the short calls be assigned, which will close out the entire position. Or you can roll up and out, say, establishing a 1x2 in March expiration with $22.50/$27.50 strikes. This would secure some "profits," or lock in some recouped money while maintaining the long exposure.

If expiration is still a few weeks or months away but you want to close out the position, I would just unwind the position: Sell the long stock at $23 and get out of the 1x2 spread, which should be showing a nice profit. Depending on how much time is remaining, though, that will be less then the maximum $4,300 if it were held to expiration.

Selling puts will only make you longer with great risk and limited profit potential. Remember, the position is fully covered; long 1,000 shares, long 10 calls vs. short 20 calls. So you don't need to offset anything.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.