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Following up

an earlier post regarding my distaste for momentum markets and reluctance to buying new highs, I should admit I actually tend to start looking for ways to establish short or bearish positions when markets enter these types of straight-line run-up conditions. Standing in front of a runaway train can be a very dangerous and unprofitable game. That is why my first rule is to limit risk by using options.

Within that framework, I tend to look at using call-credit spreads, which are bearish, and establishing a stop-loss level based on the underlying stock price. By selling a call spread for a credit, two items work in your favor: Because the position benefits from time decay, it can still turn a profit if the stock remains flat or moves even moderately higher. Using a spread, which is a limited-risk position, establishes a natural stop, or maximum loss. Also, the spread, as a simultaneous purchase and sale of similar options, mitigates the impact of changes in implied volatility which, during earnings season, can be quite dramatic.

But since most credit spreads offer a higher maximum risk than reward, I also like to set up a stop-loss for exiting the position based on the price of the underlying shares. On the other side, as far as taking profits, I use a rule of thumb of taking profits once the position has achieved around 75% to 80% of the maximum profits.

A Steely Example

Let's look at an example of how this might work. Earlier in the week,

I mentioned that I thought steel stocks, such as

U.S. Steel

,

(X) - Get Report

,

AK Steel

(AKS) - Get Report

,

Reliance Steel

(RS) - Get Report

and

Nucor

(NUE) - Get Report

, were looking overbought, and I was looking to set up a bearish position. On Tuesday, I pulled the trigger on one of the names for the Option Alert Model Portfolio, but because the position is still open, we'll use an "XYZ" example to illustrate the call-credit spread strategy.

Assume XYZ was trading around $71 per share. One could sell the May 70 calls for $3 and buy the May 75 calls for $2 net credit for the spread. The maximum loss would be $3, or $300, per contract spread if shares of XYZ were above $75 on the May 8 expiration date. The maximum profit is $2, or $200, per contract spread if the shares are below $70 at expiration. But note that the position can actually turn a profit if the shares remain at $71, or even rise to $71.99, (excluding commissions of course) at expiration.

To further reduce my risk, I will initially set a mental stop-loss that if the stock rises above $74, I'll close the position. If this occurs within the next two weeks, the value of the spread will increase to approximately $3.50, meaning I incur a $1.50 loss. Setting that stop loss tilts the position to a more favorable risk/reward.

But as time moves toward expiration, the higher long call with the higher strike price, in this case the $75 call, will offer less protection as time decay depresses its value and delta, that is, its ability to increase in value as the stock rises. For this reason, once the position is two weeks from expiration, I would lower the stop-loss to a price at or just above the breakeven point, in this case, $72 per share.

You Got the Silver

Now to the good side, taking profits. Assuming a flat stock price, meaning XYZ remains around $70 per share, just as risk increases as expiration approaches, reward diminishes. This is the reason for my "taking profits at 75% to 80% of maximum profits" rule above, in which I'll close the position at that point, regardless of the time frame.

In this case, it would mean buying back to close the spread for a net 50 cents for the spread. So, basically we end up with a position that has a one-to-one risk/reward; make a $1.50 or lose $1.50, an even money play. At that point in time, the short options' delta will start to approach 1.0 and make the position equal to just being outright short the stock.

An even-money play may not seem exciting, but consider yourself the casino in this case, in which the house takes its

vigorish

for accepting the risk of paying a large payout. In this case, thanks to time decay, and hopefully being right on your directional bet, you get to scrape all chips off the table for taking on the other side of the bullish trade and handling the action.

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 appreciates your feedback;

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