Responses to last week's article recommending shorting Biotech HOLDRs ( BBH) clustered around what is becoming a common theme -- namely, alternatives to a suggested strategy; some individuals want to know the pros and cons of a variant position.

Thanks for that column on selling calls. What about just buying puts on BBH? Can you explain the pros and cons of this approach? -- L.M.

Very simply stated, while both have a bearish bias, they're two very different positions. Since I addressed this in a previous forum, I'll move quickly through this subject. Shorting a call creates a bearish position with a limited profit potential. But time decay, as represented by theta, works in your favor, while being long a put provides a limited risk but a profit potential limited only by the fact that BBH cannot fall below zero. You own an eroding asset with a finite life span. Also, the delta of the two positions moves in opposite directions to a change in the price of the underlying stock. Meaning that as BBH's price declines, the short call's delta also declines, making it less bearish, while the long put would exhibit an increased delta (measured in a negative number due to it being a short position) as BBH's price drops.

Now, for what I really wanted to address this week, I'll use the next question as a springboard to explore how parallel replacement positions can reveal the fundamentals of option pricing:

Steven, your advice is good and easy to understand. Keep it coming, but the only thing I would add is that a lot of us, me included, cannot sell naked calls regardless of the margin requirements. An alternative for us would be helpful also. Thanks. -- K.L.

An alternative to shorting calls would be to short puts against short stock (I'll address dealing with broker restrictions another time). For example, let's assume XYZ Corp. is trading at $50, and the at-the-money put and call are both trading at $2. The profit potential and risk profile of selling the call short at $2 vs. shorting the XYZ shares at $5 coupled with shorting the puts at $2 (creating a covered put) are nearly identical and therefore represent interchangeable positions.

While a dynamic options marketplace has nuances (which include the cost of carry, such as prevailing interest rates and stock-specific dividend payments that can cause put prices to be slightly higher than corresponding call prices) that make some incremental price disparities actionable only to professionals or market makers, the basic concepts are important for all option investors. Looking at prices in terms of synthetic equivalents will often reveal alternative strategies at more advantageous prices.

My Brain's Too Small to Box Options

Probably the most fundamental way to build a relationship that creates an option chain relative to underlying stock price is the box spread. While the box spread's implications come intuitively to some people, it's not a simple concept to grasp. Not being mathematically-oriented myself, I still struggle with divining its implicit message of highlighting the mispricing, or "out of line" valuation, of specific options.

A box spread is a four-sided option spread that involves a long, a call and short put at one strike price, as well as a short call and long put at another strike price. Essentially, this creates both a synthetic long position and a synthetic short position using different strike prices.

If all option prices are "in line," a box spread represents a riskless position. For example, let's assume ABC Corp. is trading at $52.50 and you sell the 50-55 box, meaning you sell the $50 call and the $55 put and buy the $50 put and $55 call. If all strikes are trading at parity, or in line, this should net you $5, because you're creating a synthetic short at $55 and simultaneously a synthetic long at $50. At expiration the position must be worth $5. This relationship holds true among all strikes, so the 45-55 box is worth $10, just as the 50-60 box should be worth $10.

Once you understand this dynamic, if you're given the prices of three strikes you can determine the fair value of the fourth piece of the box, regardless of the price of the underlying stock. This helps you recognize when any one option price gets out of line; it can be bought or sold, then hedged using the other three strikes to create a risk-free arbitrage situation.

Working the Market

For professionals and market makers, boxes -- and their relatives, the conversion and reversal -- are basically risk-management tools or interest rate plays. But for the rest of us, they provide a great way to see how multiple-strike positions can be broken down into the component parts, making it easier to scan for equivalent replacement positions.

We've all been frustrated being unable to get a tradeoff at what we believe is a "fair price" in our chosen strike. Being able to look at other strikes and identify better prices when confronted with wide bid/ask spreads or thinly traded issues (or any other obstacle that keeps us from establishing our position of first choice) is invaluable. The flexibility to move to a second, third or even fourth alternative will allow you to execute more trades, and hopefully, be more profitable.

I know this covered a lot of ground, but I'm off next week (it's my honeymoon!), so I wanted to give you plenty to chew on while I'm gone. I'll be ready to tackle your questions when I return.

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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