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.