In a recent article, you wrote: "Way out of the money options are best used for installing up side protection on short position." Would you please explain this in greater detail? I am interested in trading options, but am still in the learning process. Thanking you in advance, D.C.

I consistently try to convey that the great thing about options is their flexibility, because few rules are written in stone and there is really no one right way of doing things, so I was somewhat surprised to see I had made such a blanket statement.

I looked at the referenced article to find the context and it does indeed need some clarification and explanation. As it turns out, the above statement was one of four suggested situations in which using out-of-the-money options might make more sense than in-the-money. The context and three other suggested uses in the article were:

Too often, investors buy out-of-the-money options simply because they have a lower absolute cost than those that are in-the-money. One of the most common complaints of individuals who buy options is that the options "don't work" when they experience a situation in which the buyer accurately predicted the direction and even the magnitude of movement in the underlying share price, but the option's value barely changed.

Way out-of the-money options are best used for:

  • long-dated expirations that allow time for the predicted price move to occur;
  • very high-beta stocks whose price can undergo double-digit percentage changes on any given day;
  • employing "what if" insurance in case of a catastrophe; and
  • installing upside protection on a short position in case of a potential melt-up resulting from a short squeeze, favorable ruling or other parabolic-inducing influences.
  • Let me expand on No. 4. Buying cheap calls is a great alternative to using a stop-loss order. This is especially true, as the statement above suggests, when establishing a short position in highflying, momentum-driven, heavily-shorted or hard-to-borrow stocks, as well as in anticipation of a price-moving event such as earnings. (These situations are prone to having an initial dramatic spike that takes out all the existing stop orders resting at the obvious resistance levels.)

    We've all felt the pain of being stopped out at the high and then watching the stock retreat after the initial overreaction. For recent examples, look at Apple's ( AAPL) earnings report or the action in Travelzoo ( TZOO).

    Up or Down, Hold Your Ground

    Buying out-of-the-money calls allows an investor to keep the discipline of limiting losses while maintaining the existing short position. In fact, not only won't you get stopped out of your shorts on a sharp move up, but you might end up making money on the long side.

    Understanding the concept of an option's delta is important in figuring out how much it will cost to gain a certain amount of upside protection and determining at what level it should be placed.

    Generally, an at-the-money call has a delta of 0.50, meaning that for every dollar of change in the underlying stock price, the call option's price will move 50 cents. For example, if you were short 1,000 shares of XYZ Corp. at $50 per share, you would need to purchase 20 of the $50 calls to have full protection from losing any money should the stock rise above $50. Of course, the cost of the calls would reduce your effective sale price of the stock by the total premium amount paid, which also represents the position's risk or potential loss.

    Because a delta is defined on a slope, meaning that as the stock price moves up and down, the option's value changes at an increasing or decreasing rate, the number of options contracts needed to be hedged for an anticipated price movement can be calculated for various strike prices.

    In the example above, what started as a delta-neutral or fully hedged position will become increasingly long or bullish as the price of XYZ rises above $50. Ultimately, it would have a delta of positive 10, equal to being long 1,000 shares. If the stock falls, you become increasingly short. The position ultimately could have a delta of negative 9.99 based on the 1,000 shares short; theoretically, the calls will retain some fractionally positive delta. This concept can be applied to adjust your protection so it matches your market expectations and risk profile.

    Because we are looking for protection against a relatively large price move, we would look at further out-of-the money calls that will be less expensive. Assume you wanted to limit your upside risk to a 20% move, or prices above $55. You could buy 20 of the $55 call options, which (assuming there are 30 days remaining until expiration) initially have delta around 0.25. But the delta will increase to 0.50, making the 1,000 shares of XYZ sold short fully hedged once the share price rises above $55 per share.

    What's nice is that not only are the losses on the short stock limited, but the position now stands to profit should XYZ keep climbing. Remember, a position's delta is cumulative, meaning it is the sum of the values of all its parts at any given time and price and at $55 the position's delta is about to turn positive. The 20 call contracts represent 2,000 shares of stock, so ultimately the position could be net long 1,000 shares.

    F5 Networks Ahead of Schedule

    On Wednesday you suggested a bullish calendar spread on F5 Networks (FFIV). Two days later the stock is up over $3 and through the strikes ... now what? -- D.G.

    You make this sound like a bad thing. Yes, I admit, that the suggested calendar spread turned out to be not exactly the best strategy, given F5 Network's inexplicable $3.15 jump on Thursday, a day the Nasdaq sustained a 1.5% decline. And yes, buying short-dated, out-of-the-money calls, which is often not more than a longshot, would have delivered tremendous profits. That said, we must deal with the choices we've made.

    At this point, I would not make any adjustments, with shares of F5 trading at $46 per share, the long January/February $45 call spread is now worth $1.70, a modest gain over the original $1.20 purchase price. But with earnings still yet to be released on Jan. 19 (again, I'm at a loss for why the stock jumped on no apparent news), the January calls are retaining their high implied volatility, near the 70% level and relatively rich. Priced at $2.10, there is still more than $1 of premium.

    Once earnings are released next Wednesday and with expiration looming on Friday, all the juice should be squeezed out of those January calls. Then, on Thursday, you can assess the situation and see what adjustments you might want or need to make based on the stock price. In other words, for now I'm still hoping that F5 hangs around $45 until next Friday.

    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@thestreet.com.

    More from Options

    Let the Najarian Brothers Crash-Proof Your Portfolio

    Let the Najarian Brothers Crash-Proof Your Portfolio

    Let the Najarian Brothers Help You Generate Income With Options

    Let the Najarian Brothers Help You Generate Income With Options

    All Investors Can Trade Options, Just Ask the Najarian Brothers WATCH VIDEO

    All Investors Can Trade Options, Just Ask the Najarian Brothers WATCH VIDEO

    Learn Options Trading from the Najarian Brothers, the Best in the Business

    Learn Options Trading from the Najarian Brothers, the Best in the Business

    Call Options Score Big in Russell 2000

    Call Options Score Big in Russell 2000