For some money managers, a singular focus on shorting may have become an unhealthy -- and unprofitable -- obsession. In light of the recent market action, it may make sense for bears to pick up some calls to hedge against further rallies. In fact, in a recent column , Jim Cramer proposed using options -- specifically calls -- to provide some upside protection.

But that's not happening yet, according to Mike Schwartz, chief option strategist with Fahnestock's Oppenheimer division. Schwartz has seen "only a minimal" amount of calls being purchased to hedge short positions.

In the Bear Cave

Cramer said recently that he expects to see money rotating into large-cap industrial names and thinks these stocks might outperform small-cap and technology stocks over the next few months.

On Tuesday, Prudential issued an upgrade on a host of industrial companies, including some that Jim named, such as Honeywell ( HON) and Dow Chemical ( DOW).

Because most of these stocks have relatively low betas and sport correspondingly low implied volatilities, their options prices are fairly inexpensive. Using the leverage that options provide could offer a great opportunity to play catch-up for individuals or money managers who are underinvested or missed some of the current rally.

For example, with Dow Chemical -- now trading at roughly $32 a share -- you could buy the September 30 call, which is trading at $3, and the September 35 call at 60 cents. While buying either strike independently provides great upside exposure, I think buying the spread (buy the 30 call and simultaneously sell the 35 call) for a net debit of $2.30 is a good alternative. The maximum profit of $2.70 (a 117% gain) is achieved if Dow climbs to $35 by the September expiration.

The table below compares the profit profile of the spread vs. being outright long either of these two strikes. While the upside may be limited, a 100% gain is realized under a much smaller move.

Profit Profile for Dow Chemical Options
September Calls/Spread with Dow's stock at various prices on Sept. 19 expiration
DOW Stock Price September 30 Call September 35 Call September 30/35 Spread
$30 ($300) ($60) ($230)
32.50 (50) (60) 20
35 200 (60) 270
40 700 440 270
Source: TSC Research

Why is using spreads more attractive than the outright purchase of calls? Well, spreads reduce your cost while allowing you to maintain a similar potential profit for a relatively small price move. This would allow bears to purchase several call spreads in various equities in order to gain broad upside exposure at minimal risk and dollar commitment.

The Bullish Side

Maybe you've been playing the long side during the latest rally. While you're counting up your profits, you may also be considering more cautious options plays to keep your gains intact.

"The recent market rally has caused a noticeable shift in how people are positioning their portfolios," Schwartz adds. Many investors have shifted from using covered call strategies, which provides only limited downside protection while capping future gains, to buying protective puts to lock in current gains no matter how steep the decline. "A combination of a decline in option premium prices and the belief that stocks have further upside potential has made option purchases the preferred method of hedging."

Buying puts against an existing long position, sometimes known as a married put, essentially acts as an insurance policy against future declines in the price of the underlying stock. Just like insurance, the longer the term and the greater the dollar amount of coverage, the more expensive the policy.

As I've discussed in previous articles on hedging , sometimes the cheapest option doesn't provide the best value. That column explains how, on a cost-per-month basis, at-the-money LEAPs (Long-Term Equity AnticiPation Securities) usually provide the best value.

Suppose you're long homebuilding stocks such as Hovnanian ( HOV) or Beazer Homes ( BZH), which have soared 90% and 62%, respectively, in the past three months. If interest rates rise, these stocks could come crashing down. A purchase of puts would allow you to lock in profits while leaving you open to further gains.

Other candidates for a married put purchase might be biotechnology stocks. For example, the Biotech HOLDRs Trust ( BBH) has jumped some 25% in just three weeks to $121 per share. You could now buy the January 2004 120 put for $9, effectively locking in a sale price no lower than $111 between now and the January 2004 expiration.

As the market has rallied in recent weeks, the implied volatility in most option prices has declined. That lowers the price of both puts and calls, making their purchase a smart way to either capture more upside gains or protect against a possible decline.
Steven Smith writes regularly for 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.