How do i short a stock using options

Difference Between Short Selling And Put Options.

Short selling and put options are essentially bearish strategies used to speculate on a potential decline in a security or index, or to hedge downside risk in a portfolio or specific stock.

Short selling involves the sale of a security that is not owned by the seller, but has been borrowed and then sold in the market. The seller now has a short position in the security (as opposed to a long position, in which the investor owns the security). If the stock declines as expected, the short seller would buy it back at a lower price in the market and pocket the difference, which is the profit on the short sale.

Put options offer an alternative route of taking a bearish position on a security or index. A put option purchase confers on the buyer the right to sell the underlying stock at the put strike price, on or before the put’s expiration. If the stock declines below the put strike price, the put will appreciate in price; conversely, if the stock stays above the strike price, the put will expire worthless.

While there are some similarities between the two, short sales and puts have differing risk-reward profiles that may not make them suitable for novice investors. An understanding of their risks and benefits is essential to learning about the scenarios in which they can be used to maximum effect.

Similarities and Differences.

Short sales and puts can be used either for speculation or for hedging long exposure. Short selling is an indirect way of hedging; for example, if you have a concentrated long position in large-cap technology stocks, you could short the Nasdaq-100 ETF as a way of hedging your technology exposure. Puts, however, can be used to directly hedge risk. Continuing with the above example, if you were concerned about a possible decline in the technology sector, you could buy puts on the technology stocks in your portfolio. Short selling is far riskier than buying puts. With short sales, the reward is potentially limited (since the most that the stock can decline to is zero), while the risk is theoretically unlimited. On the other hand, if you buy puts, the most that you can lose is the premium that you have paid for them, while the potential profit is high. Short selling is also more expensive than buying puts because of the margin requirements. A put buyer does not have to fund a margin account (although a put writer has to supply margin), which means that one can initiate a put position even with a limited amount of capital. However, since time is not on the side of the put buyer, the risk here is that the investor may lose all the capital invested in buying puts if the trade does not work out.

Not Always Bearish.

As noted earlier, short sales and puts are essentially bearish strategies. But just as the negative of a negative is a positive, short sales and puts can be used for bullish exposure.

For example, if you are bullish on the S&P 500, instead of buying units of the SPDR S&P 500 ETF Trust (NYSE: SPY), you could theoretically initiate a short sale on an ETF with a bearish bias on the index, such as the ProShares Short S&P 500 ETF (NYSE:SH). This ETF seeks daily investment results that correspond to the inverse of the S&P 500's daily performance; so if the index gains 1% in a day, the ETF will decline 1%. But if you have a short position on the bearish ETF, if the S&P 500 gains 1%, your short position should gain 1% as well. Of course, specific risks are attached to short selling that would make a short position on a bearish ETF a less-than-optimal way to gain long exposure.

Likewise, while puts are normally associated with price declines, you could establish a short position in a put (known as “writing” a put) if you are neutral to bullish on a stock. The most common reasons to write a put are to earn premium income, and to acquire the stock at an effective price that is lower than the current market price.

For example, assume a stock is trading at $35, but you are interested in acquiring it for a buck or two lower. One way to do so is to write puts on the stock that expire in say two months. Let’s assume that you write puts with a strike price of $35 and receive $1.50 per share in premium for writing the puts. If the stock does not decline below $35 by the time the puts expire, the put option will expire worthless and the $1.50 premium represents your profit. But if the stock does decline below $35, it would be “assigned” to you, which means that you are obligated to buy it at $35, regardless of whether the stock subsequently trades at $30 or $40. Your effective price for the stock is thus $33.50 ($35 - $1.50); for the sake of simplicity, we have ignored trading commissions in this example.

An Example – Short Sale vs. Puts on Tesla Motors.

To illustrate the relative advantages and drawbacks of using short sale versus puts, let’s use Tesla Motors (Nasdaq:TSLA) as an example. Tesla manufactures electric cars and was the best-performing stock for the year on the Russell-1000 index, as of Sept. 19, 2013. As of that date, Tesla had surged 425% in 2013, compared with a gain of 21.6% for the Russell-1000. While the stock had already doubled in the first five months of 2013 on growing enthusiasm for its Model S sedan, its parabolic move higher began on May 9, 2013, after the company reported its first-ever profit.

Tesla has plenty of supporters who believe the company could achieve its objective of becoming the world’s most profitable maker of battery-powered automobiles. But it also had no shortage of detractors who question whether the company’s market capitalization of over $20 billion (as of Sept. 19, 2013) was justified.

The degree of skepticism that accompanies a stock’s rise can be easily gauged by its short interest. Short interest can be calculated either based on the number of shares sold short as a percentage of the company’s total outstanding shares or shares sold short as a percentage of share “float” (which refers to shares outstanding minus share blocks held by insiders and large investors). For Tesla, short interest as of Aug. 30, 2013, amounted to 21.6 million shares. This amounted to 27.5% of Tesla’s share float of 78.3 million shares, or 17.8% of Tesla’s 121.4 million total shares outstanding.

Note that short interest in Tesla as of April 15, 2013, was 30.7 million shares. The 30% decline in short interest by Aug. 30 may have been partly responsible for the stock’s huge run-up over this period. When a stock that has been heavily shorted begins to surge, short sellers scramble to close their short positions, adding to the stock’s upward momentum.

Tesla’s surge in the first nine months of 2013 was also accompanied by a huge jump in daily trading volumes, which rose from an average of 0.9 million at the beginning of the year to 11.9 million as of Aug. 30, 2013, a 13-fold increase. This increase in trading volumes has resulted in the short interest ratio (SIR) declining from 30.6 at the beginning of 2013 to 1.81 by Aug. 30. SIR is the ratio of short interest to average daily trading volume, and indicates the number of trading days it would take to cover all short positions. The higher the SIR, the more risk there is of a short squeeze, in which short sellers are forced to cover their positions at increasingly higher prices; the lower the SIR, the less risk of a short squeeze.

How Do the Two Alternatives Stack Up?

Given (a) the high short interest in Tesla, (b) its relatively low SIR, (c) remarks by Tesla’s CEO Elon Musk in an August 2013 interview that the company’s valuation was rich, and (d) analysts’ average target price of $152.90 as of Sept. 19, 2013 (which was 14% lower than Tesla’s record closing price of $177.92 on that day), would a trader be justified in taking a bearish position on the stock?

Let’s assume for the sake of argument that the trader is bearish on Tesla and expects it to decline by March 2014. Here’s how the short selling versus put buying alternatives stack up:

Short sale on TSLA : Assume 100 shares sold short at $177.92.

Margin required to be deposited (50% of total sale amount) = $8,896.

Maximum theoretical profit (assuming TSLA falls to $0) = $177.92 x 100 = $17,792.

Maximum theoretical loss = Unlimited.

Scenario 1 : Stock declines to $100 by March 2014 – Potential profit on short position = (177.92 – 100) x 100 = $7,792.

Scenario 2 : Stock is unchanged at $177.92 by March 2014 – Profit / Loss = $0.

Scenario 3 : Stock rises to $225 by March 2014 – Potential loss on short position = (177.92 – 225) x 100 = - $4,708.

Buy Put Options on TSLA : Buy one put contract (representing 100 shares) with strike at $175 expiring in March 2014. This $175 March 2014 put was trading at $28.70 / $29 as of Sept. 19, 2013.

Margin required to be deposited = Nil.

Cost of put contract = $29 x 100 = $2,900.

Maximum theoretical profit (assuming TSLA falls to $0) = ($175 x 100) - $2,900 (cost of put contract) = $14,600.

Maximum possible loss = Cost of put contract = -$2,900.

Scenario 1 : Stock declines to $100 by March 2014 – Potential profit on put position = (175 – 100) x 100 minus the $2,900 cost of the put contract = $7,500 – $2,900 = $4,600.

Scenario 2 : Stock is unchanged at $177.92 by March 2014 – Profit / Loss = Cost of the put contract = -$2,900.

Scenario 3 : Stock rises to $225 by March 2014 – Potential loss on short position = Cost of put contract = -$2,900.

With the short sale, the maximum possible profit of $17,792 would occur if the stock plummeted to zero. On the other hand, the maximum loss is potentially infinite (loss of $12,208 at a stock price of $300, $22,208 at $400, $32,208 at $500 and so on).

With the put option, the maximum possible profit is $14,600, while the maximum loss is restricted to the price paid for the puts, or $2,900.

Note that the above example does not consider the cost of borrowing the stock to short it, as well as the interest payable on the margin account, both of which can be significant expenses. With the put option, there is an up-front cost to purchase the puts, but no other ongoing expenses.

One final point – the put options have a finite time to expiry, or March 2014 in this case. The short sale can be held open as long as possible, provided the trader can put up more margin if the stock appreciates, and assuming that the short position is not subject to “buy-in” because of the large short interest.

Applications – Who Should Use Them and When?

Because of its many risks, short selling should only be used by sophisticated traders familiar with the risks of shorting and the regulations involved. Put buying is much better suited for the average investor than short selling because of the limited risk. For an experienced investor or trader, choosing between a short sale and puts to implement a bearish strategy depends on a number of factors – investment knowledge, risk tolerance, cash availability, speculation vs. hedging, etc. Despite its risks, short selling is an appropriate strategy during broad bear markets, since stocks decline faster than they go up. Short selling carries less risk when the security being shorted is an index or ETF, since the risk of runaway gains in them is much lower than for an individual stock. Puts are particularly well suited for hedging the risk of declines in a portfolio or stock, since the worst that can happen is that the put premium is lost because the anticipated decline did not materialize. But even here, the rise in the stock or portfolio may offset part or all of the put premium paid. Implied volatility is a very important consideration when buying options. Buying puts on extremely volatile stocks may require paying exorbitant premiums, so make sure the cost of buying such protection is justified by the risk to the portfolio or long position. Never forget that a long position in an option – whether a put or a call – represents a wasting asset because of time-decay.

The Bottom Line.

Short selling and using puts are separate and distinct ways to implement bearish strategies. Both have advantages and drawbacks and can be effectively used for hedging or speculation in various scenarios.

Short selling vs. purchasing a put option: how do the payoffs differ?

Purchasing a put option and entering into a short sale transaction are the two most common ways for traders to profit when the price of an underlying asset decreases, but the payoffs are quite different. Even though both of these instruments appreciate in value when the price of the underlying asset decreases, the amount of loss and pain incurred by the holder of each position when the price of the underlying asset increases is drastically different.

A short sale transaction consists of borrowing shares from a broker and selling them on the market in the hope that the share price will decrease and you'll be able to buy them back at a lower price. (If you need a refresher on this subject, see our S hort Selling Tutorial .) As you can see from the diagram below, a trader who has a short position in a stock will be severely affected by a large price increase because the losses become larger as the price of the underlying asset increases. The reason why the short seller sustains such large losses is that he/she does have to return the borrowed shares to the lender at some point, and when that happens, the short seller is obligated to buy the asset at the market price, which is currently higher than where the short seller initially sold.

In contrast, the purchase of a put option allows an investor to benefit from a decrease in the price of the underlying asset, while also limiting the amount of loss he/she may sustain. The purchaser of a put option will pay a premium to have the right, but not the obligation, to sell a specific number of shares at an agreed upon strike price. If the price rises dramatically, the purchaser of the put option can choose to do nothing and just lose the premium that he/she invested. This limited amount of loss is the factor that can be very appealing to novice traders. (To learn more, see our Options Basics Tutorial .)

How to Sell Stock Short.

Investing Online For Dummies®, 7th Edition.

Ordinarily when you invest in stocks online, you hope to profit from a company’s good times and rising profits . But there’s a whole other class of investors, called shorts, who do just the opposite. They search the Internet for news stories about diners getting food poisoning at a restaurant, for instance, and look for ways to cash in on the stock falling.

To sell a stock short, you follow four steps:

Borrow the stock you want to bet against.

Contact your broker to find shares of the stock you think will go down and request to borrow the shares. The broker then locates another investor who owns the shares and borrows them with a promise to return the shares at a prearranged later date. You get the shares. Don’t think you’re getting to borrow the shares for nothing, though. You’ll have to pay fees or interest to the broker for the privilege.

You immediately sell the shares you have borrowed.

You pocket the cash from the sale.

You wait for the stock to fall and then buy the shares back at the new, lower price.

You return the shares to the brokerage you borrowed them from and pocket the difference.

Here’s an example: Shares of ABC Company are trading for $40 a share, which you think is way too high. You contact your broker, who finds 100 shares from another investor and lets you borrow them. You sell the shares and pocket $4,000. Two weeks later, the company reports its CEO has been stealing money and the stock falls to $25 a share. You buy 100 shares of ABC Company for $2,500, give the shares back to the brokerage you borrowed them from and pocket a $1,500 profit.

When you short a stock, you need to be aware of some extra costs. Most brokerages, for instance, charge fees or interest to borrow the stock. Also, if the company pays a dividend between the time you borrowed the stock and when you returned it, you must pay the dividend out of your pocket. You’re responsible for the dividend payment, even if you already sold the stock and didn’t receive it.

How to Short Stocks Using Options.

Hard-to-borrow shares can be replaced by purchasing puts.

By Lawrence Meyers, InvestorPlace Contributor.

There’s a major downside to trading stocks now that every man, woman and child has a brokerage account. In the old days, you could pretty much short any stock you wanted. However, now that shorting is as easy as making a TV dinner, at times you might not even be able to find shares to borrow from your broker to short. Shares that are particularly hard to borrow might even come with a fee attached — usually expressed as an APR you must pony up. If that APR is too high, it can really cut into profits.

I’ve run up against this problem several times over the past few years. However, there is a solution, and it can be utilized without having to pay any fees. If you buy deep-in-the-money puts, you are effectively shorting the stock because there will be little if any premium on puts that are deep in the money.

Before I hit some examples, however, I want to mention the only types of stocks I’ll consider this strategy for.

Stocks that are clearly headed for bankruptcy: It might take awhile to get there, but these are companies who do not have a sustainable business model. Their days are numbered, but enough people are holding out hope that it gives the stock more value than it should have. Stocks that are insanely overvalued: One must proceed with caution here, because if it’s insanely overvalued, that doesn’t mean it can’t go higher. Momentum stocks can burn you. The criterion here is that the stock is trading at far higher multiples in relation to even the craziest possibilities for growth. Stocks in what have become “sunset industries”: These will take awhile to develop and pay off, but they will. Newspaper stock McClatchy (MCI) is a perfect example.

So here are some examples of shorts where I can’t find shares to borrow, but I can buy puts.

Groupon (GRPN) has cratered since its IPO. It once sat at $26; now it’s at seven bucks. It trades at a P/E of 41, yet I see only 10% revenue growth going forward. I don’t think the company has a sustainable business model. It’s easy to replicate and has been. It has direct, focused competitors like LivingSocial , and Google (GOOG) and Amazon (AMZN) have gotten into the game. I think Groupon will go under, but I can’t short the stock. In this case, you don’t want to pay a premium when the stock is so close to zero. So, buy the January 2014 17 put for $10. Now you are effectively short the stock, and still able to exit by selling it for either a profit or loss anytime between now and expiration.

Life Partner Holdings (LPHI) was once the leader in life settlement contracts. This is a transaction where someone sells their life insurance value at a discount to collect money in the here and now. The buyer basically hopes the seller will die in a time frame such that they receive a good return on their investment. However, the company is under investigation and shareholder lawsuits. LPHI trades at $3, and management keeps pumping out massive dividends it can’t afford. I can’t find shares to short, but the October 7.50 put is going for $4.50.

I don’t believe SodaStream (SODA) has a sustainable model. I just don’t think people will use the product over the convenience and cheaper alternative of just buying soda at the store. The stock trades at 28 times earnings and has no free cash flow. It trades at $70 and I can’t find shares to short, but I can buy the October 95 Puts for $27.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc. , which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs . Contact him at pdlcapital66gmail and follow his tweets ichabodscranium .

Article printed from InvestorPlace Media, investorplace/2013/06/how-to-short-stocks-using-options/.

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