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Don't Be Fooled by False Protection

Selling out-of-the-money calls is not the same as taking money off the table by selling stock.
Author:

Selling an out-of-the-money call is not the same as selling the stock. I don't know how I can be more plain about that. Those who think they are taking it off the table by selling an out-of-the-money call are just kidding themselves. Those written calls will not protect you from downside. They will only make the ordeal more problematic.

I can't emphasize to you enough how my logic on this issue is both rigorous and empirical. As one of the largest options traders on the Street for years and years, I can tell you that if you think selling a call is protective, you are just smoking something that doesn't fly in my house.

In a severe market breakdown the price of the call you sold might actually expand as volatility can make calls more expensive. You can get the gain until you buy the calls in, but chances are the premium in the call will be so pumped up that you won't want to do that until it is too late and the common is so low that the call didn't make you enough money.

Brokers love it when you sell calls. It is a regular commission generator and you feel like you are doing something safe. You feel like you are taking stock off the table and raising cash.

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All you are doing is locking in a terrible trade if the market really takes a bath and cutting off your upside if it doesn't. That's the worst of all possible worlds. I know -- I have done it hundreds of times. Hundreds of times I found myself caught with a big decline in the common and a small gain in the short call. Hundreds of times I have cut off my upside or lost a common stock position before a big move because I wanted to pick up a few bucks selling an expensive call.

Use me as your laboratory. I am not trying to make any money off you or gather assets from you or make commissions from you. I am just telling you the way it is. (I will rewrite this article Saturday for those who are lost in the terminology.)

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund had no positions in any stocks mentioned. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

jjcletters@thestreet.com.