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Educational Article

Naked Calls for the Chicken-Hearted

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When we visited last week we talked about bullish put credit spreads as a way to sell naked puts with a security blanket. This week, we will visit its twin, but mirror-image sibling, the bearish call credit spread.

Remember the premise last week on making put credit spreads work. We sell a put and want time decay to work on the other guy. Ideally, the option expires worthless to the buyer right into our account as the underlying directional bias is up (bullish) or at least stays even. If we are wrong, our security blanket comes in the form of a lower strike long put to hedge the short higher strike put. While it is still possible to lose money on the position, the potential loss is known before we enter the position, and we are generally protected from wiping out the account on unforeseen negative events.

See last week's article at:
http://members.OptionInvestor.com/options101/060301_1.asp

A bear call credit spread is the same; only we are looking for bearish price action of the underlying stock to help make the time decay work in our favor. In expectation of a downward move, we sell a call for a premium and let time decay go to work on the buyer. Just in case we are wrong and prices unexpectedly rise, we will protect ourselves by simultaneously purchasing a higher priced strike call for less money. Even after the long purchase, we are left with a net credit in the account and we know our maximum loss in the worst-case melt-up.

Ideally the position expires worthless and we keep the premium for having taken the risk.

The strategy is to sell calls at the high. Let us use SMH, or the Semiconductor HOLDR as an example. Generally speaking, SMH and the SOX have similar chart patterns, even though their components are strikingly different. But in the world of indexes, semiconductors are semiconductors no matter how you slice them. If we look at a SOX chart, we will see two occasions in the last three months where the index went to roughly 700 and rolled over. Corresponding numbers for the SMH would be about $54.

So figuring that SMH should roll over at about $54. that might make further weakness a high probability outcome. If we believe $54 is a top, we would sell ATM ($55 in this case) calls. Since there is not much time premium left in the JUN strikes, we will move out to JUL strikes and sell the JUL-55 call for a current bid of $2. But to hedge our position, we would simultaneously buy the JUL-60 call for $0.85 just in case we are wrong and SMH becomes the next rocket ship to the moon. After all, who wants to sell naked JUL-55 calls and have to cover at $75 on a monster gap up? Not me!

Ice cubes would sooner form in the Sahara, but that is why we hedge. After all, an enterprising desert-dweller could have discovered electric generators and compact freezers today with plans to roll out ice-cubes tomorrow. Again that is why we hedge - to quantify and minimize risks of unexpected turn of events.

Anyway, the upshot is a net credit of $1.15 per share ($2 - $0.85) immediately in the account. You can increase the credit slightly if you are adroit at legging in or squeezing the market maker for a few extra nickels by splitting the bid and ask on each leg of the position. Realistically, this could be increased to $1.35 to $1.40 by performing the latter. But let us stick with conservative numbers. The bottom line is that we stand to keep the whole $1.15 upon expiration in the best-case scenario. The worst case is that we lose $3.85. How did we come up with that? Follow along.

On expiration, we have three possible outcomes. First, SMH is less than $55 and we keep the whole $1.15 - the most probable if history is to repeat itself and we are correct in our judgment of the price about to fall.

Second, SMH can close between our strike prices of $55 and $60. At $55.50, we are "forced" to buy at $55.50 and sell at $55 for a $0.50 loss. However, we have taken in a credit already for $1.15, which still leaves us with a $0.65 profit even if we get "called out"! The math, if SMH closed exactly at $56.15, would put us at break even. . .buy at $56.15, sell at $55 for $1.15 loss, but with an initial credit of $1.15, we are at break even.

Since we run out of credits at $1.15, every cent above $56.15 results in a corresponding penny loss to the account. Say that SMH closes at $58. We are "forced" to buy at $58, sell at $55 for a $3 loss. Offsetting with the $1.15 credit puts our actual loss to the account at $1.85. (In reality, our broker will do all the math and we will not generally be forced to buy shares and resell them for a loss - the difference just disappears from the account. But check with your broker for details as each can vary).

Third, and this is how we come up with the maximum loss of $3.85, say SMH closed at $62.50. Are we forced to buy at $62.50 and sell at $55 for a $7.50 gross loss, but a net loss of $6.35 considering our initial $1.15 credit? No way. Because we hedged and bought the $60 strike call, we have the right to buy SMH at $60! We do not have to pay $62.50. Thus, we buy at $60, sell at $55, credit $1.15, and we have a maximum loss of $3.85. Even if SMH goes to $100 overnight, our hedge is in the right to buy SMH at $60 and minimize our loss at $3.85.

While losing $3.85 is no fun, it sure beats losing more, and allows us to keep heart palpitations to a minimum even though the trade has gone a zillion dollars in the other direction. Preferably, we close the trade for less than maximum loss if it goes against us by buying back the short and selling back the long calls. I set an arbitrary number to exit when the underlying hits my breakeven - $56.15 in the above example. At that point, I will be pretty sure the trade is going against me and exit for a smaller than maximum loss. But we all get to choose based on our own risk profiles.

Now that we have gone through this process, this is not a no-brainer recommendation to put on this trade first thing Monday. In my opinion, this trade does not offer enough credit reward to justify the downside risk. I like at least $1.75 - ideally $2.50 - for every $5 in strike difference. That means I can gain $2.50 or lose $2.50. My chance of gain is about 67% based on the Black Shoals pricing model. How does that work? Please do not e-mail me for an explanation. I have no idea, but I know it works. You can type Black-Scholes into any search engine and come up with more than you could ever want to know on the subject. The point is that the more credit you can get, the more you minimize the potential loss by default.

There you have it! A great way to take advantage of time decay in your favor rather than let it fritter away while playing a directional move or running in place. For those who want to sell short with a safety net, here is another arrow for your quiver.

Now, you too can get the time decay of naked calls and keep your heart rate low in the process!

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