Options Mailbag: Short the Transports

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

In this week's Options Mailbag, we tackle questions regarding the best way to short the transportation sector.

Hey Steve, I'm looking to get short the transports, is there a good way to use options?

-- JM

In my first round of give and take with JM, I asked what he meant by the transports, as there are many subsectors: airlines, truckers, railroads and shipping companies.

After a little research, we were both stymied by the fact that we could not find exchange-traded funds that have a concentration in any in of these areas. Our conclusion was that in each area, there are only a handful of stocks, making the logistics of creating an index for each inefficient.

But with new ETFs being rolled out every day, we could be wrong. So before I give my suggestions, I'll ask a question. Does anyone know of some ETFs that focus on a specific part of the transportation industry?

The major benchmark is iShares Dow Jones Transportation Average ( IYT), but it covers a mix of all the businesses mentioned above.

Still, if you want to be bearish or short the sector, there are several ways to use options. The first and cleanest would simply to be buy put options. But I don't like that because the options are thinly traded, which results in wide bid/ask spreads making it costly to enter and exit positions.

For example, with IYT trading around $92, the September 90 puts is $3 bid and offered at $3.50. Even if you can execute a trade in the middle at $3.25 and the same occurs on exiting the position, that amounts to i5% of the option's fair value. In trading parlance this is known as slippage, and combined with time decay, it creates a tremendous headwind owning options.

Sell Write Might be Right

I'd rather use a strategy that sells options and takes in premium. The most obvious strategy would be to sell calls. But many people can't short options naked.

One step down on the risk ladder would be to use a sell-write. This consists of shorting the stock and simultaneously shorting put options. This is essentially the inverse of a covered call or buy-write.

Of course, one drawback is that the capital requirement will be significantly higher than simply buying puts or a put spread. One will need to meet the margin requirement of shorting the stock, which is typically 50% of the share price minus the premium collected.

Sticking with the IYT as an example, if you sold 1,000 shares and shorted 10 puts, you would have to pony up $41,500. Let's assume you want to go ahead with this trade; you short the stock at $92 and sell the September 90 put at $3.25 a contract. That gives you an effective sale price $95.25, or 3.4% above the current market price.

But like a covered call, your profit is capped by the stock price minus the strike price plus by the premium collected. In this case, that is $5.25 (92 - 90 + $3.25 = $5.25). That would be a 5.7% gain over the next two months.

Be aware that like a covered call, a sell-write offers limited protection. That means that if the IYT rises above the $95.25 breakeven point, losses will begin to mount.

My preference would be to apply this strategy to specific stocks. Airlines seem like ripe candidates. Their shares have rebounded sharply as the price of oil has tumbled, and the implied volatility of their options is near 52-week highs.

Let's look at Continental Airlines ( CAL), which recently traded from a 52-week low of $6, to $14 a share. One can short the stock and sell the August 12.50 put for $1 per contract. That gives you an effective sale price $15 a share which is a resistance level. The potential profit is $2.50, or 17%, over the next three weeks.

If the trade works out, you'll be able to splurge and check a second bag on your summer vacation.

This was originally published on RealMoney on August 1, 2008. For more information about subscribing to RealMoney, please click here. Plus, to subscribe to "Options Alerts," click here.
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 appreciates your feedback; click here to send him an email.

To read more of Steve Smith's options ideas take a free trial to TheStreet.com Options Alerts.

If you liked this article you might like

The Influence of Option Expiration

The Influence of Option Expiration

Options Mailbag: Not All Merger Strategies Are Created Equal

Options Mailbag: Not All Merger Strategies Are Created Equal

Lehman's Options Plays Suggest Fear

Lehman's Options Plays Suggest Fear

Three Potent Tech Options Plays

Three Potent Tech Options Plays