Using Options to Protect Yourself in a Dangerous Time

The forum looks at hedging, covering shorts and putting on a collar.
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Protecting against a market downturn has taken on even greater importance given the week's events. In this week's installment we'll investigate how to put on and cover shorts as we demystify what these terms actually mean. Also, how can a "collar," a "fence" and a "hedge-wrap" mean the same thing and have nothing to do with the dog in the backyard?

As always, keep sending your questions, along with your full name, to the

Options Forum.

Short Options

Are there option strategies that augment short stock positions? Steve Gikas

Steve, it depends on what you mean by "augmenting," says Adam Benowitz, a former

Amex

floor trader, now manager of the

MBA

, or Municipal Bond Arbitrage, hedge fund.

"If it's hedging, then that's easy: Sell puts or buy calls. If you're aping a short stock position with options, then sell calls and buy puts," Benowitz says. "If you want to short

Amazon.com

(AMZN) - Get Report

at 100, for instance, sell the 100 calls; if the stock goes to that level, you sell it at 100 plus whatever premium you took in. Or you can buy puts, although that's not really shorting stock. It's a short position."

Expiration Inquiry

I sold 10 contracts of America Online August 120 calls naked at 5. If the option goes out of the money by the third Friday of August, do I need to cover the naked call at 1/16 on that Friday, or do I simply let it expire and take the $5,000 profit without covering the call? Bingrong Shan

Bingrong,

"Does he need to? Absolutely not. Would I? Absolutely," says Benowitz, who obliged us with a helpful hint once again. A "naked" position, by the way, is one in which the investor doesn't hold the underlying stock. In this case, the investor was selling calls.

"Here's my policy," Benowitz says. "Cover all naked positions, especially now and in an Internet stock like

America Online

(AOL)

. For the simple preservation of capital, I'd cover now. How? Buy cheap puts now and forget about it. That gives you the opportunity, if the stock comes back $50, which it's been known to, to have peace of mind. You can move on to the next trade."

Again, does this person have to cover? "No. His only risk is that somebody will exercise the calls and he'll be short the shares, since he sold the calls naked," Benowitz says. "The puts are trading at about 1/4

$25 per contract, so it's not a wasted quarter. He will have done the right thing. And if he really thinks the stock's going down, then he can go out and sell the 100 calls for even more premium. By covering, it gives you the opportunity to trade again. Never ever went broke covering a short position."

Currently there are two weeks left until August expiration, and "I'm a big believer of covering your shorts," he adds. "Let's say the stock was trading at 115 and it was expiration day. I'd still cover with an option costing as little as 1/16 ($6.25). Options don't technically expire until Saturday; and who knows? Maybe that's the one-in-a-thousand-chance weekend that AOL would get taken over. So cover yourself at a teenie-weenie price; only costs you a few hundred bucks. You made $4,750. Once that's closed you can't lose. If it's still open you can always lose."

Employee Covering

I'd be interested in your opinion on the following strategy: writing naked calls on stock that is "covered" by employee stock options. If you hold deep in-the-money vested and exercisable employee stock options, and you write out-of-the-money call options at a strike price that you'd be happy to exercise your options at to maximize the premium you receive, is this a sound strategy? Even if the stock price rises, you can roll the options at a higher strike price and still be money ahead while securing a higher ultimate selling price for your options. By way of clarification, to maximize the premium received, I've been writing calls on LEAPS "secured" by stock options. I'm an active buyer of calls on LEAPS on big-cap stocks, and have had great success (50%-100% gain in less than six months). I've never had much success buying or selling short-term options. Bob Agans

Bob, we consulted Brad "Doc Option" Zigler of the

Pacific Exchange

for these queries, and his first reaction to the first was:

"Perhaps so, but what kind of time would you need to exercise your company stock options and actually take delivery of the stock? Can you meet the T+3 delivery requirement if you're assigned on the written calls? Additionally, your broker won't consider the written calls 'covered' for margin purposes because the underlying stock doesn't reside in your account. You'd have to meet a naked short margin requirement."

Collars

What is the strategy called when you sell at-the-money puts to fund the purchase of out-of-the-money calls with the same expiration on the same security? If you were short the stock already, and wanted to hedge against a possible upside swing in the underlying stock over a short period of time while remaining short the underlying stock, would this strategy be advisable since it would involve no out-of-pocket expense? Joseph Fenway Kelmon

Doc Options responds again: "You're referring to a position known as a 'collar,' a 'fence' or a 'hedge-wrap,' depending upon what option trading school you attended. Most people know the reverse version, a long put financed by a short call.

"However, that represents a hedge if you are long stock. In your case, the long call/short put combination acts as a sort of synthetic long stock to offset the price risk of selling stock short. But it may not be a 'no-cost' position.

"Your broker won't recognize the stock short sale as margin coverage for the written put. If your account equity doesn't meet the naked margin requirement, you may have to pony up dollars out of pocket."

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.