There’s a lot of hype and misinformation surrounding the idea of short selling. In fact, it’s become almost a bad word in many circles, especially if the shorting is being done on such seemingly patriotic financial instruments like the U.S. dollar.
Last week, the Securities and Exchange Commission (SEC) voted 3-2 to impose new limits on short selling; a move that SEC Chairman Mary Schapiro claims will “preserve investor confidence.”
This is a bizarre comment, in my opinion, as short selling is nothing more than a way for investors to speculate on the direction of the market or a stock.
So why would the SEC want to impose new restrictions on short selling? And, more importantly, how can investors sidestep these new restrictions and continue betting on the decline of a particular equity or market sector?
Let’s first take a closer look at the new rule, and then we’ll see how you can sidestep it.
As you likely know, short selling is essentially borrowing stock and selling it with the expectation that the share price will fall at some point in the future. If everything works as planned, short sellers then buy back the shares at the lower price. They then return the shares to the original owner and pocket the difference as their profit.
Some people blame short sellers for helping to force down the share price of a company, but this idea ignores the fact that you wouldn’t short a company in the first place unless you had some reason to believe its shares were going to head lower.
The new SEC regulation puts curbs in place on shorting stocks that decline at least 10% in a single day. In applicable cases, the SEC will allow short selling only if the price of the sale is above the highest bid price nationally. Basically, the short seller is blocked from dumping shares at a low price. These curbs will apply for the remainder of the day the stock falls 10%, as well as on the following trading day. This is basically just a variation of the so-called “uptick rule,” which was done away with in 2007, that enabled investors to short a stock only after it ticked higher.
Of course, there is no real evidence that these curbs will do anything to help investors, or investor confidence, but lack of evidence never stopped a government regulator from tinkering with the free market.
Oh, and the new rule, which takes effect in six months, will cost the securities industry $1 billion to implement and another $1 billion annually to maintain. Big cost to industry is another thing regulators care little about.
Put Options: The Short-Selling Restriction Antidote
So, if you are a frequent short seller — or even just an occasional short seller — this new rule could put a crimp in your style. The good news, however, is that there is a better way to bet on the decline in a stock, and that is by using put options.
Put options are perhaps one of the easiest options plays out there. Basically, you are betting that a particular stock (or market sector) is going to go down, and the put option gives you the right (but not the obligation) to sell the underlying stock at the strike price on or before expiration. Buying a put essentially allows you to lease the downward price movement of a stock.
For example, if a stock is priced at $50 and you buy a 50 strike put, you have the right to sell 100 shares of the stock at a price of $50 per share no matter how low the market price of the shares goes. If the stock drops to $40, you can buy 100 shares for $4,000 and then turn around and sell them for $5,000 using your put.
Of course, you don’t have to actually buy the shares to profit. Another way to profit from puts is to sell your put option for a profit. If you buy a 50 strike put for $2 ($200 per contract) and the stock drops to $45 at option expiration, your put is now worth $5 ($500 per contract). That represents a 150% profit on your initial investment.
Using puts allows you to avoid any restrictions on short selling set by the SEC, and it also allows you to profit from the decline in a stock or index’s price without having to put up the cash in your margin account to borrow the shares the way you have to do when shorting a stock.
Sure, there is time decay when using options that you don’t have when shorting a stock, and you do pay a premium for this time element. However, with options you control when the put is sold or exercised — and you don’t have to worry about the SEC stepping in and telling you what you can and cannot do.
Related Articles:
- The Best Way to Short Stocks
- How to Pick the Right Put Option
- 5 Rules for Making Big Profits Shorting Stocks
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