Shorting stocks through options

By: ispeculatornew
Date posted: 11.13.2013 (5:00 am) | Write a Comment  (0 Comments)

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Through my long and short technology stocks, I very frequently end up shorting tech stocks. For various reasons, many investors cannot or prefer to not short the stocks. Why? There are several possible reasons:

Account Type Does Not Permit it: If you have a retirement account a cash account, you are likely unable to short stocks.

Avoiding Excessive Risk: If you have ever considered shorting stocks, you would probably know that the potential loss on such a trade is basically unlimited. In reality, no stock will go to infinity overnight but it still gives you a good idea that such a trade can end up going awfully wrong.

Expensive or Impossible Borrow: A reader had emailed me a few weeks ago saying that some of the stocks that I was shorting were basically impossible to borrow with his broker. In some cases, while the borrow is possible, the costs are so excessive that it’s not something you’d really consider doing.

What Can Be Done?

If someone is trying to do a trade such as Long Apple (AAPL) and short Microsoft (MSFT) but cannot or will not short Microsoft, one alternative would be to trade the options. There are two different bets that will give you a positive return if Microsoft does not increase as much.

Short Call: If you sell calls on Microsoft, you will end up making money if the stock price does not increase much. Here is the chart of profits and loss on selling calls:

payoff-short-call-option-microsoft

However, shorting a call will help on the borrowing side of the equation but not so much with the unlimited loss… depending on the reason why you’re looking to trade options, this might or might not work.

Long Put: If you buy a put option, you are basically buying the to sell the stock at some later date. The return chart is much more similar to shorting the stock as you can see here:

long-put

The main disadvantage here is that since you are buying the stock (Google) and the put option, this trade requires more capital. When you a do buy and sell, the trade does not require much if any capital at the start.

The Dangers

1-One of the dangers of using options instead of stocks is that options do not always react in the same way as stocks. They have a different “delta”. For different reasons, options will end up moving differently. The best way to ensure that the options does move in the same or very similar way is to trade options that have a delta of 1 or so.

What is an option that has a delta of 1?

An option that is well in the money which means that it is almost certain to be exercised at expiry will have a delta of nearly 1 which means that it will move like the underlying stock.

2-A second danger is buying illiquid options and get a poor execution price. The best way to avoid this is to only buy stocks that have a very tight bid-ask spread, ideally of $0.10 or less.

Have You Ever Tried It?

Have you ever shorted a stock through options instead of stocks?

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