Protect Those Bets on the Short Side

Editor's note: This column was originally published March 11.

The current wisdom says that once war with Iraq starts and it becomes apparent the U.S. has things well in hand, stocks are poised to rally sharply, possibly even marking the end of the bear market and the beginning of a new bull. This view has many short-sellers, now in the fourth year of their post-bubble feast, not wanting to overstay their welcome. They're getting nervous and quick to cover. And I believe that after so many months of anticipation, the commencement of military action will bring an initial rally.

But until proven otherwise, we're still in a bear market for stocks. So it seems to make sense to me that rather than fight the tape from the long side, investors should keep an eye out for opportunities to make money from the short side.

Short Until Proven Long

While it's definitely a little late in the game to begin a wholesale short-selling campaign, looking at ways to establish and maintain some selective short positions might be useful.

I and others have described how recent activity in the options market has been dominated by covered-call writing as investors look to generate income while preserving the potential for upside gains. If longs can try to improve their cost basis by selling options, so can the shorts.

In this column I'm going to describe the mirror image of covered calls: selling puts against a short stock position. What's better is the fact that puts generally -- and that's the case now -- sport slightly higher premiums than calls, providing an improved rate of return.

Some option positions simply make sense based on an attractive risk/reward profile, regardless of a market opinion. Covered stock positions (long or short) aren't in that category. They should have some fundamental or technical backing, and hopefully both, on which the trade rests.

Your entry or sale point must be clearly defined. Just as long-term investors are advised not to try to pick the exact bottom, shorts know that a year's worth of profits could be wiped out in few days should the market turn. That means not trying to squeeze out every last penny of profit and instead keeping the discipline of stop losses firmly intact.

Standing Out

Cognizant Technology Solutions ( CTSH) seems like a fine candidate for a covered put.

First of all it operates in the space of e-business software, an area in which renewed spending is arguably suspect, and the stock still sports a multiple of more than 40 times 2003 earnings estimates. More importantly, the chart looks lousy.


Be Cognizant ...
And be careful at these levels

The stock is already rolling over here at $70, and support doesn't come until the gap formed between $63 and $64.50. In early trading Monday morning, with the stock at $69, one could sell the April $65 put for $2. That would give you a purchase price of $63, for a maximum potential profit of $6. The break-even point is $71.

On the basis of the chart, an investor should use a stop to close out the position (buy back both the short stock and short put) if it closes above the recent high at $71.20. On Tuesday the stock traded below $67. The chart still looks bearish, but unless you are an aggressive short, you might want to wait for slightly better prices before putting on the position.

Devon Energy ( DVN) is another potential covered put candidate. The shares rose to $50.30 last month after the company announced plans to acquire Ocean Energy ( OEI).


Trouble Near
Devon might work as an energy short

Now it looks like the stock will have trouble crossing and closing above the $51 to $52 level. With Devon trading at $49.50, the April $45 put can be sold for 75 cents. This provides profit potential down to $44.25 and a break-even of $50.25.

Then there's Nike ( NKE). I don't think the swoosh will have the juice to break through resistance at $52.


Marathon or Sprint?
Caution may be the best approach here

With Nike trading at $48, the April $45 put was trading $1. I would suggest being patient here and seeing if Nike can trade back to the $50 range before initiating a position.

Keep in mind these are just examples. There are other stocks and sectors that could be considered for this type of strategy, such as hotel and leisure stocks. Even though these names have already taken it on the chin, it might take them a while to get up off the mat, considering that the unknowns about war and terrorism continue to dominate the headlines.

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.

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