Contents
- What Does It Mean To Short A Stock?
- What Are The Pitfalls Of Shorting A Stock?
- How To Short A Stock With Options?
- Put Options
- Call Options
- Covered Put
- Bear Put Vertical Spread
- Bear Call Vertical Spread
- Synthetic Short
- Conclusion
Going “short” or “short selling” sometimes receives negative attention in the media.
Often, it’s blamed for exacerbating falls in the stock market (and therefore the economy) or for making a trader go bankrupt.
The reality is that over-inflated bubbles and poor risk management contribute most to these cases.
When used correctly, shorting with options forms a viable and important part of a trader’s toolkit, allowing them to profit on the declining performance of a stock.
What Does It Mean To Short A Stock?
Most people are familiar with the common way to make money through stocks which is that you make money when the price of the stock rises.
To do this, you buy a stock in the hopes that the value of the stock will rise so you can sell it at a future date for a higher price than you bought it.
Shorting a stock works in the reverse way in that you make money when the price of the stock falls.
To short a stock, you sell it first and once the value of the stock declines you buy it back at a lower price than what you paid for it. If all goes well of course.
What Are The Pitfalls Of Shorting A Stock?
The biggest risk to shorting a stock is the potential to lose more capital than you put at risk. To understand how this happens, let’s first look at a regular trade where you go long.
With a long trade, assuming no leverage, your maximum possible loss is the amount of capital you invested in the stock.
For example, let’s say you buy 100 shares of ABC stock at $50 a share, for a total investment of $5,000.
Let’s take a scenario, of the company going bankrupt. As a result, the price of the stock falls to $0.
All 100 shares are now worth $0 and as a result you lose all of your initial $5,000 investment.
Let’s use similar starting numbers for a short sale. We sell 100 shares of ABC stock at $50 a share, pocketing $5,000.
Overnight, ABC’s major competitor goes bankrupt and the price of the stock shoots up to $200.
If you were to buy your 100 shares back, it would cost you $20,000 (100 shares x $200). You’ve lost four times more than your original investment of $5,000.
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As the price of a stock can theoretically rise forever (check out TSLA in Feb 2020), it means your risk on a short sale is unlimited, whereas when going long, the lowest a price can go to is $0 so your maximum loss is always your initial investment.
How To Short A Stock With Options?
When shorting a stock using options, there are some features that differ to a regular short sale of stock.
The main one is that using options will impose a specific time limit on the short position due to the option expiry date.
When the option expires, you’ll either need to close out the position or meet any obligations that the options contract has on you.
As a result, shorting a stock using options is generally better suited to short-term bearish views, while traditional short sales have no time limit so are generally used for long-term bearish views.
What are the strategies for shorting stocks with options?
Put Options
The simplest way to short a stock using options is to buy a put option.
A put option will usually gain in value due to either a decrease in the underlying stock price or an increase in volatility.
Time decay works against you with a long put option, so it’s important you give yourself enough time for the trade to work in your favor.
The key to trading well with long put options, is to balance paying as little as possible with achieving the highest profit potential.
This means trying to select the best strike price within the right time frame.
You’ll need work out this balance according to your own forecasts and overall risk tolerance.
Generally speaking, so that you give yourself enough time for the trade to work in your favor, try to give yourself at least six months (i.e. buy put options that expire in more than six months).
If you are going for less than six months, consider buying deep in the money (ITM) options instead but be aware this approach will be more expensive.
Call Options
Selling a call option (also known as a naked call option) allows you to profit by pocketing the premium for writing the option, provided the price of the stock doesn’t increase by much.
Unlike buying a put option, with this trade time decay works in your favor so you want to sell call options with as little time to expiration as possible.
Bear in mind that time decay accelerates exponentially in the last month before the expiration date, so use this to your benefit.
On the surface, while selling a call option looks like a simple strategy similar to buying a put option, it is a trade that’s recommended for experienced traders only.
The reason being is that your upside is capped by the price of the premium, however you have unlimited downside risk so you can lose a lot more than the amount of premium collected.
To avoid being too exposed, try and select a strike price around areas of strong resistance in the downtrend.
Be aware of your own risk tolerance levels and strike an appropriate balance with collecting as much premium as possible and limiting your risk.
Covered Put
A covered put (also called a married put), is done by shorting stock and then selling out of the money put options in direct proportion to the shares shorted.
Think of it like a covered call but in reverse.
In this way you are fully offsetting your market position (hence the term “covered”) and you can share in some profit from stock declines while taking advantage of a contraction in volatility.
In this trade, time decay is working in your favor due to the reduction in the value of the put option.
You can either sell the premium every month or sell premium a long way out.
If you sell it every month, as long as the underlying stock does not reach the strike price at expiration date, you will benefit from the full premium of the stock.
If you choose to sell premium a long way out, you’ll have the benefit of retaining your short stock position however the rate of time decay will be lower.
Bear Put Vertical Spread
A bear put vertical spread is used when a trader is moderately bearish on a stock and is looking to make a gain at a reasonable cost.
If a trader is very bearish, they’re often better off buying a put option as it allows them to gain a potentially unlimited profit.
With this type of trade, the short leg of the spread caps your maximum profit but serves to reduce your cost and increase your leverage.
To execute a bear put vertical spread, buy at the money put options while simultaneously selling out of the money put options with exactly the same expiration date.
Try to give yourself at least six months to expiration to maximize the time you have to be correct in your analysis.
As there are many, many bear put spread combinations available, pick one that matches your risk appetite and forecast.
Bear Call Vertical Spread
Similar to the bear put vertical spread, the bear call vertical spread is used when a trader is moderately bearish.
It allows a trader to limit their risk exposure while earning an income from their bearish analysis.
To execute this trade, sell a call option while simultaneous buying further out of the money call options.
Like the bear put vertical spread, both options need to have the same expiration date.
The options you sell serve to produce income, while the options you buy are used to limit your risk exposure.
As time decay works in your favor for this trade, it works best during the last month left before option expiration.
Like the bear put spread, there are many possible combinations so pick the one that best matches your risk appetite and forecast.
Synthetic Short
A synthetic short mimics the characteristics of an ordinary stock short.
To create a synthetic short, you buy a put option and sell a call option at the same strike price as well as the same expiration date.
If the price of the underlying stock declines, then the value of your put option increases and you generate a profit.
If however the price of the underlying stock increases, then the value of the call option you sold will increase while the value of the put option will decrease.
The net result is that your overall position will be at a loss, which you pay back in much the same way you would with an ordinary short.
Conclusion
Shorting stocks with options allows you to profit from stock price declines by collecting premiums and/or making a gain from the change in value of the option.
As with regular short strategies, there is the potential for unlimited risk with certain trade types, so always ensure you trade those strategies you’re familiar with and always consider your risk tolerance and risk mitigation strategies.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
