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Short Selling Strategies: How To Avoid The Short Squeeze With Put Options
by Karim Rahemtulla, Advisory Panelist
Editor, The 400 Report
Friday, June 19, 2009: Issue #1022
“Investors are worrying that a three-month surge in stocks might be overdone.” - So read a piece of market commentary from the Associated Press a few days, as the Dow, S&P 500 and Nasdaq all slumped.
Thanks for the heads-up, guys. You’re about two months too late. Not only did we call the bear market rally before it began, we’ve also spent the past couple of months warning you not to get swept away by the sudden surge of optimism and over-confidence as stocks have pushed higher.
Bear market rallies are fun while they last. But they’re only temporary. And the last week of sharp sell offs reminds us that the market has an uncanny knack of sucking the wind out of your sails when you least expect it.
But far from being gloomy, it also reminds us that there’s just as much opportunity to make money from the downside as the upside. But you need to do it the right. When you’re bullish on the market or a stock, you go long. When you’re bearish, you go short. Here’s how you can profit from market pullbacks with some short selling strategies and protect yourself in the process.
Short Selling Strategies – Dangerous For Pro & Rookie Investors
Short selling strategies can spell great risk and danger for rookies – and many professionals.
Many investors believe that the best way (and sometimes the only way) to make money from a falling market or stock is to “short” it. So let’s quickly go over the mechanics of how short selling works…
- You sell shares of an asset into the market before buying them. Because you’re anticipating a drop in price, you’re hoping to buy the shares back at a lower price once this happens. Short sellers sometimes aren’t popular because they’re hoping the market and/or stock goes down.
- You go short by “borrowing” the shares from someone who is long on the asset (you don’t own the shares when you go short) and hope that it tanks. So when you buy the shares, you’re essentially replacing the shares that you borrowed.
- If you’re right and the asset falls, you profit because the shares you buy back are cheaper than when you borrowed them.
But what if you’re wrong and the asset rises? The real danger is that a stock – theoretically – could go to any price and you’d be stuck with the difference. It’s the nightmare scenario…
The Short Squeeze: On the Wrong Side of Short Selling
Let’s say, you short an asset that you are convinced is about to decline, but it turns the tables on you and rises instead. You’re now on the hook to buy the shares at a higher price than you borrowed them – you’re on the wrong side of a short squeeze.
- A short squeeze puts short sellers in a losing position, faced with the prospect of unlimited losses as the asset rises. The more people who went short, the more severe the reaction will be.
- In a panic, they all pile into the stock at the same time, trying to buy back the shares to cover their trades and get out of them. This is known as short covering. The buying demand, coupled with the lack of sellers drives the price up even more, thus adding to your unlimited losses.
For example, let’s say you shorted 1,000 shares of Boeing (NYSE: BA) at $35 where it was three months ago. That would have given you $35,000. But you’d still have to replace those shares eventually because you only borrowed them.
But Boeing has performed very well over the past three months and is trading around $50 today, so if you hadn’t covered your shares till now, you’re forced to buy them back for $50,000 – at a loss of $15,000. And the more the stock rises, the more you lose on your original investment.
You never want to be in this situation, period.
Short Selling Strategies: Lower Your Risk With Put Options
Here’s an easy short selling strategy to make sure that you’re not on the wrong side of unlimited short losses again:
- If you think an index or stock is set for a fall, buy put options on it. This allows you to play the downside, but with far less risk than if you shorted the stock.
- When you buy a put, you have the right, but not the obligation, to sell the shares. That means your loss is only limited to the amount you pay to buy the option contract if the asset rises. No more. And if it falls, your put makes money.
For example, let’s say that instead of shorting Boeing shares at $35, you’d bought put options instead, trading at $1 per contract. Ten contracts (the equivalent of 1,000 shares, since one contract is made up of 100 shares) would have cost you $10, putting your total risk at $1,000.
That’s much better than the $15,000 you’d have lost by shorting the stock.
Short selling strategies can be extremely profitable if you’re right… but very risky if you’re wrong because your losses are unlimited.
So keep an eye out for stocks that are overpriced and ripe for a decline, or economic/company news that could drag them down. And if you want to play the downside, do it with put options.
Good investing,
Karim Rahemtulla
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7 Responses to “Short Selling Strategies: How To Avoid The Short Squeeze With Put Options”
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Karim Rahemtulla is one of the country’s foremost specialists in options trading and Investment Director of Mt. Vernon Research, as well as the founder and editor of Strategic Income, The 400 Report and Investment U. 
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June 19th, 2009 at 5:37 am
In your example of Boeing,how do you get fro a cost of $10 for the cost of 10 contracts at a “$1 per contract” to a “total cost of $1,000 ” ??
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Celeste Flynn Reply:
July 15th, 2009 at 6:26 am
It’s not well explained in the article, but here’s the answer. Each option contract represents 100 shares, so if an option is quoted at $1.00, you actually spend $100 to buy the individual contract. Therefore, if you buy 10 put contracts at $1.00 per share, you’re actually buying the right to sell 1,000 shares of the underlying stock at the strike price on or before the options’ expiration.
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June 19th, 2009 at 11:54 am
On shortselling vs buying puts
You did not mention that once you buy the put, to get your money back and then some you want to the stock to go down and you need to by sell the put to make the money you mention. IF you buy the put it just gives the right to get the stock at a lower price but most who do options are not interested in owning the actual stock.
I like selling a put I make the money right away and I could buy puts on something that if it goes wrong and the stock is put to me I wanted the stock and got it cheap.
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Celeste Flynn Reply:
July 15th, 2009 at 6:41 am
I beg to differ. When you buy a put, it does *not* give you the right to “get the stock at a lower price.” Instead, it gives you the right to *sell* the stock at a specific price on or before expiration. As long as the stock price has dropped below your strike by more than your cost of the put, you are profitable even if you hold until expiration. So, if you buy puts, you had better not be interested in owning the stock, but rather in selling it.
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June 20th, 2009 at 12:24 am
A good educative article on Short Selling.
Sir, Your opinion on after the2-3 month recent run up of , if one has lot size stock of a scrip,and wants to protect the capital against the expected downfall , what is preferable:
a. To short the Future or
b. To short the call of little higher strike price,
c. To buy the Put of a little lower strike price ?
Please advise and thanks
Reply
Celeste Flynn Reply:
July 15th, 2009 at 6:59 am
I note Mr. Rahemtulla hasn’t answered you, so I’m jumping in. I have no opinion about shorting the Future (I assume you are referring to a single stock future?). But if you own stock you want to protect against an expected downfall, there is actually little difference between b. and c., except whether the trade will be a debit or a credit. If you only do b., you will receive a credit, and effectively reduce your cost basis in the stock. But you limit your potential upside if the stock increases. If you do c., you are expending a debit, essentially buying insurance against a downturn. Another possibility is to do both b. and c., which is also called a collar. This can often be done for little cost beyond commissions, as the credit for b. might be very similar to the debit for c. In this case, you both insure against downside loss and limit the upside, but if you are more concerned about the downside risk, it can be a good strategy.
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June 21st, 2009 at 1:33 pm
Great Story! As A Beginning Adventure Capitalist, I Have Worked Long And Hard For My Money. I do NOT Want To Lose My Hard Gotten Gains By Not Knowing What I am Doing In The Market Trading Business. I Once Had An Old Man Tell Me When I Was Young , He Worked HARD All His Life But Never Made Any Money Until He Started Investing In The Market, AFTER HE RETIRED! I Am Now 50 Years Old And This Old Man Told Me This When I was About 19 Years Old. I Have Never Forgot What He Told Me. I KNOW There Are Easier Ways To Make Money And NOT Cheat People Doing It! I Also Know That The World May Not Have Another Chance Such As NOW To Get RICH Investing The RIGHT Way! Thanks For The Insight.
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