Shorting stocks is a strategy often misunderstood and sometimes blamed for downturns. In this article, we will discuss how to short a stock using options; thus, making money even when the market is showing a downward trend.
What Does Shorting a Stock Mean?
You are likely familiar with the fundamental trading strategy of buying low and selling high. This strategy involves tracking the market for opportune moments when you can buy an asset at a low price and wait for its price to go up so that you can sell it for a profit.
However, assets do not always see a price rise. How do you make money when assets see a decline in value? With stocks, you can do it by shorting (or short selling) them.
To short a stock- you borrow shares and sell these borrowed shares at the current market price. When the price of the shares falls, you buy them at a lesser price than you sold it and return the shares back to the original lender.
Example of Shorting a Stock
Here’s a simple example to understand how shorting works. Let’s consider you have a margin account with a brokerage that holds shares of company ABC. These shares are currently trading in the market at $100. However, you expect the price to fall in some time.
You borrow 100 shares of ABC through your margin account and sell these shares in the market for a total price of $10,000 (i.e., 100 shares x $100).
Now, the share price has fallen to $80. You buy the 100 shares for a total price of $8,000 (i.e., 100 shares x $80) and return the 100 shares to the brokerage, along with the related fees and interest, if any.
Your approximate profit is $2,000 ($10,000-$8,000), or $20 per share.
Issues With Shorting a Stock
Like all trading strategies, short selling comes with inherent risks. In fact, you could say that the risk when you short a stock is more significant than the usual “buy low, sell high” strategy.
In the above example with company ABC, what happens if the share price goes up instead of falling?
The stocks you borrowed had been sold at a total price of $10,000 (i.e., 100 shares x $100). Now, suppose the price has risen to $120 per share.
You still need to return the borrowed stocks to the brokerage. Here, you will be forced to buy 100 shares for $12,000 (i.e., 100 shares x $120), you end up losing $2000 ($12,000-$10,000) i.e. $20 per share.
This potential for a significant loss is why short-selling is recommended only for experienced investors who can read the market better. One way to lower the risk involved in shorting is to do it with an index or ETF. Another way is to use put or call options.
Shorting a Stock With Options
Options are contracts that give the option holder the right—but not the obligation—to buy or sell the underlying asset at a predetermined price on or before a specified date.
Call options are right to buy the asset, while a put option is the right to sell the asset. In the case of stock options, the contract typically involves 100 shares of the underlying stock.
Shorting With Put Options
The first way is to buy put options or, as traders call it, going long on puts. Suppose the ABC stock is still priced at $100. You buy a put option at the strike price of $100 which gives you the right to sell 100 ABC shares at $100 a share, irrespective of the prevailing market price.
You will, of course, exercise this right only when the stock price falls below $100. Now, suppose the price falls to $80. You buy 100 shares from the market at a total price of $8,000 and, exercising your put option, sell them at a total value of $10,000. Your profit is $20 per share minus the nominal cost of buying the put option.
Because of the put option, note that your risk is substantially lower than if you had just shorted the stock as described earlier.
If the stock price went up instead of falling, your only loss would be the premium paid for the option. You would not exercise the put option, and it will expire on its due date.
Shorting With Call Options
Another way, though much riskier, to short a stock is the short call strategy or short selling call options. You can underwrite a call option that gives the buyer the right to buy shares from you at the same strike price.
As a seller, you are obligated to make the shares available if the option holder wants to exercise their right on or before the expiration date.
The option holder will only exercise their right to buy shares from you if the stock price exceeds the strike price. On the other hand, you expect that the price will fall so that the option expires unexercised. If the price does fall, your profit will be limited to the premium earned from selling the option.
However, if the price goes up and the holder exercises the call option, you will have to buy the shares from the market at a high price and sell them to the option holder at the lower strike price. There is pretty much no floor for the loss you may incur, while the profit potential is limited.
You can keep the strike price very high to minimize the likelihood of the call option being exercised. This makes it less likely that the price will go any higher.
However, the pricing is also determined by market dynamics, so this strategy has its limits.
A better way to lower the risk involved in selling a call option is using the covered call strategy. This is when you, as the seller of the call option, have the underlying stock already in your possession.
If the price rises and the option is exercised, you don’t have to purchase the shares at a high price. You are still making a loss by selling at a lower strike price than the market price.
However, this loss is notably lower than if you went with a naked call, that is, if you didn’t own the underlying asset.
Using Options to Bet on the Downside
Markets usually have an upside bias, making it difficult to bet on the downside. However, if you do want to profit from a bearish move, an intelligent strategy is to short a stock with options, especially going long on puts.
Besides having relatively lower risk and requiring less cash investment than shorting a stock, puts are also more liquid.
At the same time, options have risks and complexities like any investment strategy. Therefore, ensure you develop a strong understanding before diving into the deep end.
Note: The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only.