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Short Strategy Primer: Shut Up and Sell

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April 1, 2014

The term “short” has been given a bad rap over the years. And for good reason. Without even knowing what the term means, the average investor listening to pundits and naysayers would have you believe shorting will put you in the poorhouse, or that’s a part of what sunk the economy just a few years ago. The reality is while shorting is inherently risky, when used wisely, it can be useful. But in the hands of a reckless trader, that’s where the problems begin.

The term “selling short” simply means you’ve changed the typical order of operations. While most people buy a stock then sell it in a short sale, one sells a stock then buys it. While there are mechanisms that need to be in place in order for short selling to occur (such as approval to short a stock with the stock being available to short), the ability to short sell any financial instrument is a necessary component of a fair market, as it completes the opportunity to match buyers and sellers at a transaction price both parties deem fair.

The Big Risk

Of course, when you sell an option short, you incur the obligation to either buy or sell the underlying security at any time up until the option expires. Unfortunately, that obligation means you may have to either buy a stock higher, or sell it lower, than where it’s currently trading. In a nutshell, if you’re forced to fulfill the obligation that may arise from a short-option position, you’ll be forced to do something you wouldn’t otherwise do.

In the case of a short-call position, you incur the obligation to sell the stock at a set price, and there’s no limit to how much higher the stock can rise before you may have to buy it back. With a short-put position, you incur the obligation to buy the stock at a set price. And while the stock can drop considerably before you decide to sell, your risk is technically limited because stocks cannot drop below zero. Why would you do that? There are two main reasons experienced options traders might employ the short-put strategy—to buy the stock at a lower price than where it’s currently trading, or to speculate on a stock’s direction and collect periodic income from the time value of the short put.

Buying Stock at a Lower Price

With a short-put position, you take in some premium in exchange for taking on the responsibility of possibly buying the underlying security at the strike price. This money is yours to keep no matter whether the stock trades below the strike of the short-put option. At any time prior to expiration, if the stock trades at a price that is lower than the strike price, then the person who is long the put has the right to (and will likely) exercise the option. In that case, you’ll be assigned on your short-put position, meaning you have to buy the underlying stock at the strike price. Consider the following: Let’s say you’re mulling over the idea of buying 100 shares of XYZ stock currently trading at $64.50. However, you don’t want to pay more than $60 a share to own it. You could sell the XYZ January 60 put for $2.00 per contract, obligating you to pay $60 per share for XYZ stock if assigned—exactly what you wanted. But since you’re collecting $2.00 for the put, your net cost for the trade is $58 per share (plus commissions and fees).

The Scuttle On Dividends

It’s true that if XYZ stock happened to pay a dividend, then by owning XYZ you’d be entitled to that dividend. By being short a put in XYZ stock on the other hand, you would not be entitled to a dividend. That said, keep two things in mind. First, if you happen to get assigned on your short XYZ puts, then you’d be forced into taking delivery of the stock, thereby granting you the right to all future dividend payments so long as you remained the stock owner.

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FIGURES 1 AND 2: RISK CURVES OF THE SHORT PUT (LEFT) AND SHORT CALL (RIGHT).

Both strategies typically have higher probabilities of success than long trades. However, they have limited upside and have potentially unlimited risk to the downside. For illustrative purposes only.

Second, all American-style put options are adjusted to some degree for upcoming dividends. Puts sold on dividend-paying stocks are built to trade at a slightly higher premium than where they otherwise would trade if the underlying stock did not offer a dividend, all things being equal. Among other factors, the deeper in the money the put option happens to be, and hence, the greater the likelihood that your short option is assigned and converted to stock, the greater the adjustment for the dividend. So the options world has addressed that pesky concern.

What About Assignment?

If you get assigned, you take delivery of the stock at the strike price of the short put. So what now? Well, since you took in some premium via your put sale prior to buying the stock, how about taking even more premium by selling a call option after you buy the stock?

Suppose that the stock settled at $59.75 per share at expiration and you get assigned, thereby forcing you to buy shares of XYZ stock. On the following market opening after expiration, you note that XYZ is trading at around that same level, just below $60 per share. At this point, you could sell the XYZ February 60 call at, say, $4.00. This premium is yours to keep regardless of where XYZ settles at expiration.

If XYZ stays below $60 per share until expiration and you don’t get assigned, the February 60 calls go out worthless, you’re $4.00 better off than if you had done nothing. On the other hand, if XYZ trades above $60 per share prior to, or at, expiration, then you’d likely be forced to sell your stock at $60, which is the same price at which you were forced to buy it in the previous expiration. You would be no worse off, and in fact, you’d probably be better off since in addition to the premium that you collected when you sold the put, you’d also have the premium collected when you sold the call, less the applicable transaction costs like commissions, contract fees, and assignment fees.*

Selling short puts can be a great way to buy a stock you were committed to buying anyway, while allowing you to collect some additional premium through the option sale. At first glance, the strategy may seem extremely risky. And it is. However, upon closer inspection, you can see there’s potentially more risk in buying the stock outright due to the collection of the option premium. Finally, whether or not you’re assigned on your short-put option, the premium you collected during the option sale is yours to keep.

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FIGURE 3: FINDING SHORTS WITH THINKORSWIM For illustrative purposes only.

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