A short position is an investment that generates a profit if the market, a market segment or a company’s stock goes down. There are many ways to “go short:”
Shorting a Stock
On Wall Street, the expression “short” has historically meant shorting the stock. This happens as follows: You learn that the ChangeWave Alliance has survey results showing that Dell (DELL) will soon lose market share to Hewlett-Packard (HPQ).
Suppose Dell is selling at $40. You call your broker and “borrow” 500 shares of Dell and immediately sell them. Yes, sell them. The money from the sale is placed in a margin account by your broker.
Seven weeks later, the company announces it is losing market share and the price of the stock goes to $30. You buy 500 shares at that lower price, re-pay your broker, and keep the $10 difference between the price of the stock when you borrowed it and the price of the stock when you re-paid the loan.
You have a 25% profit in seven weeks, minus interest costs on the loan of borrowed stock.
Buying a Put Option
A put option contract is a contract to “put,” or force someone to buy, a stock at a fixed price sometime in the future. A put option contract has a limited duration and expires or the buyer can exercise the contract at any time during the life of the option.
Puts are used by investors going short who do not want to borrow the stock or want more leverage — a rapidly appreciating put generates a better-percentage return than a traditional short position.
Let’s look at Dell again — you decide to go short through the purchase of put option contracts. It is February; you buy a $40 put contract that expires in November. This put is selling for $3.50.
Seven weeks later, Dell releases the bad news and the stock drops to $30. The put you paid $3.50 for now sells for $12.50. Why? Because an owner of the put, on the day it can be exercised, can buy the stock in the open market for $30 and “put” that stock, or force someone to buy it, for $40, a $10 profit.
The other $2.50 in the put price is called the premium and represents the time value of money. You have a more than 300% profit in seven weeks, and you took on a whole lot less risk by buying the put options than by shorting the shares outright.
LEAPS are both calls and puts that you can hold for a longer time horizon than regular shorter-term options — up to two and a half years — which gives them potentially different tax treatment.
LEAPS are more expensive — the premiums are greater because they are held longer — but are also less volatile than shorter-term puts. You can buy a LEAP put if the slide in a company or sector is evident but looks like it will take some time to play out.
Selling a Covered Call Option
Investors don’t think of this as shorting, but it is. Selling a call option contract gives someone else the right to buy a stock at a fixed price at a fixed date in the future based on a stock you hold in your portfolio.
You are selling this call against shares you hold long because you do not believe the price of the stock will rise above the “strike price” of the call — the price at which the owner of the call can buy the stock from you. Selling a covered call at a strike price above the current price of a stock is best described as a “defensive position.”
Selling a covered call at a strike price below the current price of the stock is clearly another way to short a stock.
There are other methods for shorting a stock, such as selling a naked call (i.e., you sell a call without owning the underlying stock), but they are unsuitable for individual investors, not just because of their risk but virtually all credible stock brokers will not let individuals write naked calls.
There are a variety of ways to establish a bearish or even neutral position by shorting stocks, selling calls, or by buying shorter-term or longer-term put options. You can make unlimited profits by shorting the stock or the calls, but if the stock starts going up, you might find yourself facing potentially unlimited losses.
Only you know how much risk you can afford to take on, but if you’re looking to define your risk from the outset, then buying put options is probably your best bet. The most you can lose is what you spend to enter the trade, and the more the stock drops, the more profits you can make.