Don't Call the Top, Sell the Call

The recent rally has inflicted serious pain on those caught short. But for those of us who still have a little powder and nerve left in our arsenal, this moonshot provides another opportunity to trade from the short side. But we need to be careful.

Just as we know that trying to "catch a falling knife" in a declining market is a dangerous game, one can get equally bloodied in attempting to "lasso a rocket at its trajectory inflection point" during a rising market. OK, so my newly coined expression doesn't exactly roll off the lips ... but you get the idea.

At some point gravity kicks in, and stocks can't rise in a straight line forever. But given the market's current momentum, with many stocks hitting 52-week highs and little resistance in sight, choosing where to short shares is a difficult and potentially costly proposition. Selling call options, however, lets you establish a moderately bearish position without pinpointing the top.

Promising to Sell

When an investor shorts call options, he or she is selling a promise to deliver shares at the strike price before the expiration date. Unlike a covered call or buy-write, in which one owns the underlying security as an offset to the short call, this position is referred to as being a "naked" call seller.

The major drawback of shorting calls vs. shorting shares of the underlying is that while both present potentially unlimited losses if the stock price rises to infinity, the profit potential of the call is limited to its sale price. Assume XYZ Corp. shares are trading at $50 and you sell five July $55 calls for 80 cents each (remember: each call represents 100 shares, so the multiplier is 100 -- this provides leverage). If XYZ trades infinitely higher, you can lose an infinite amount of money. Of course, the margin requirement will prevent a position from running too far away. Short calls are subject to similar margin and maintenance margins of a straight short sale. But the profit in this case is limited to just $400 -- equal to the net sale price of the call options.

Giving Up Gains but Gaining a Cushion

A beneficial tradeoff of limiting your profit potential is that shorting calls can substantially raise your net sales price. In our example, the effective sale price is $55.80, $5.80 or 11.6% higher than the current market price of $50.

"One of the major misconceptions involved in selling naked options is the risk, when in fact it is no greater than being outright short the underlying," says Mike Schwartz, chief option strategist at Fahnestock's Oppenheimer division. Schwartz's statement echoes a general rule of thumb in options trading: Don't be naked options with more than 90 days remaining until expiration. "This allows one to take advantage of the fact that options are an eroding asset," he says. An option's time decay, as defined by theta, accelerates as the expiration date approaches.

Winning by Not Losing

This means that even if the shares of the underlying simply stall or rise slowly, the naked-call seller can still realize a maximum profit. The table below provides the profit and loss profile for our hypothetical example.


Shorting 500 Shares of XYZ at $50 vs. Shorting 5 July $55 calls
P/L Based on price of XYZ on July 18 expiration
Position $45 $50 $55 $60
Short 500 XYZ at $50 $2,500 0 ($2500) ($5000)
Short five XYZ July $55 calls at 80 cents each $400 $400 $400 ($4600)

As you can see, the risk/reward for extreme moves would favor an outright shorting of the underlying shares should there be a precipitous decline. The naked calls provide a nice means of generating a moderate profit even if XYZ climbs higher than the initial entry point.

Shorting Biotech

While shorting biotechnology stocks has proven hazardous to your portfolio's health recently, I think this group is a prime candidate for employing a short call strategy. Using the Biotech HOLDRs ( BBH) Exchange Traded Fund, or ETF, as a proxy for the group, the sector has gained some 38% over the past three months.


BBH Has Had Healthy Run
But now it needs to rest?

But I think the recent reversal off resistance at the $130 level will mute upside momentum in the near term. On Tuesday afternoon, with BBH trading at $123, one could sell the July 130 call for $3. This gives an implied sale price of $133, or 8.1% higher than the current market price. The maximum profit of $300 per call contract shorted will be realized should BBH settle at any price below the $130 strike price on the July 18 expiration.

While many stocks might seem to be hitting overbought levels, the market always seems to have a way of pushing a little further and longer than appears rational. This is where having the price cushion created by selling options can be invaluable. But remember: Shorting calls naked should be used as a relatively short-term trading tool rather than establishing a fundamentally long-term bearish position.


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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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