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The extraordinary demand for telecom stocks poses challenging problems for the money managers and individual traders who invest in them. Rising in tandem with volatility, telecom stocks tend to peak then fall, victims of the draw-down syndrome. Learning how to foresee these impending corrections is only part of the solution to keeping your head above water in the telecom sector.

Today's telecom flavors of the month include

Qualcomm

(QCOM) - Get Report

,

Cisco

(CSCO) - Get Report

,

JDS Uniphase

(JDSU)

and

Nokia

(NOK) - Get Report

-- highfliers with extremely high price-to-earnings ratios. These stocks consistently offer traders high directional risk. But it's funny: While there are legions of investors who think that investing in individual telecom stocks is too risky, these same traders are more than willing to turn their hard-earned capital over to professionals who subsequently diversify it in a telecom fund.

The problem with investing in a fund that specializes in a particular sector is that no matter how diversified the fund is, when that sector takes a hit, so does the fund. Fund managers struggle with how to hedge that directional risk.

Many hedge with bonds because in the event of a market meltdown, they theoretically act as a buffer against inflation. Others use a stock-for-stock hedge. They do this by purchasing strong stocks in the telecom sector while shorting the weak stocks. In times of turmoil, the weak stock is assumed to fall as fast or faster than the strong stock, creating a directional hedge. While this looks good on paper, correlated stocks are not a true hedge against each other.

The only true hedge against a stock involves using options to manage risk. Of the more than 20,000 stocks, about 12% have available options. Unfortunately, when most investors hear the word "options," all they can think of is risk. Most don't take the time to see exactly how options manage risk. Options, when positioned correctly, are actually one of the truest hedges. In fact, anyone with some knowledge of options can greatly reduce the risk of his or her portfolio.

Let's look at a few option strategies specifically designed to hedge directional risk using 100 shares of Nokia. The stock has climbed from 100 to more than 200 per share over the past year. At the time of writing, it was trading at 210.

Long Put

Strategy

: Buy a put to protect a long stock position from a drop in the market.

Specifics

: Buy Nokia October 200 puts at 25 (= $2,500).

Risk/Reward

TST Recommends

: $2,500 of put insurance protects the position until October. If the stock continues to rise, the position can still be profitable, but it has to overcome the cost of the long put.

Covered Call

Strategy

: The sale of a call against a long stock position by taking in premium against the owned stock.

Solution

: Sell the Nokia April 220 calls for 13 (= $1,300).

Risk/Reward

: Selling a call against a long stock position brings in an additional 13 points of premium. If the stock drops, a covered call offer would limit protection against losses. If the stock were to take a big dive, the trade could still lose a substantial amount of money. In the best case scenario, the stock price would remain above the strike price of the short call and keep rising until expiration.

Protective Collar

Strategy

: A cost-free hedge involving buying the at-the-money puts and selling the at-the-money calls at the same time to protect long stock positions.

Solution

: Buy the Nokia July 220 put at 25 (= $2500) and sell the Nokia July 220 call for 25 (= $2,500). Net = zero.

Risk/Reward

: Offers complete downside protection and allows for continued profit up to the strike price of the call sold. The premium received on the call equals the money paid to buy the put. The only negative: If the stock continues to rise above the call strike price, the call may be assigned, limiting the profit on the long stock position.

Appreciating Collar

Strategy

: In volatile stocks, sometimes at-the-money call premiums are higher than the at-the-money put premiums. Selling calls with higher premiums than the long puts garners a net credit on the trade, similar to an arbitrage.

Specifics

: Buy Nokia October 200 put at 25 (= $2000) and sell the Nokia July 220 call for 35 (= $3,500). Net = $1,500.

Risk/Reward

: Buying the put and selling the call leaves a maximum limited net credit of 15 points. If the stock rises to 220, the put would expire worthless and the call assigned would leave the trader with the original 15 points. If the stock drops to 200, the call would expire worthless and the put option would have to be exercised to cover the falling stock, realizing a profit of 15 points. (Note: It is vital to find a net profit on the position that realizes a reasonable profit after commissions.)

Although these strategies have their drawbacks, they do offer an alternative to the traditional hedge. Whatever you choose to do, it's always good to have options.

George Fontanills is one of the founders of Optionetics.com, a registered investment adviser and hedge fund manager in Boston, and the author of two highly acclaimed books, The Options Course and Trade Options Online (published by John Wiley & Sons). Tom Gentile is the chief options strategist and senior writer for Optionetics.com, as well as the co-instructor of the Optionetics Seminar Series, which is taught to sold-out crowds all over the country.

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.