How To Short A Stock With Options

How To Short A Stock With Options:  Even the most inexperienced investors know the number one rule of the stock market: buy low, sell high. Experts, analysts, and traders constantly examine data related to industries and specific organizations in search of opportunities to buy shares just before prices take off.

A lesser-known but still effective method of benefiting from movement in the market is short-selling or shorting a stock. This transaction makes it possible for investors to profit when shares of a specific company experience a decline in value.

What Does It Mean to Short a Stock?

The first point to be aware of is that short-selling carries substantial risk. It is a technique better left for experienced investors.

With that said, this strategy involves borrowing shares, selling the borrowed shares at market prices, buying them back when prices drop, then returning the lower-priced shares and keeping the difference as profit.

Basically, investors interested in short selling open a margin account with their broker-dealer. Margin accounts operate along the same lines as credit accounts, with the broker-dealer lending assets in exchange for interest payments.

To short sell, investors borrow shares that they believe are poised for a drop in value. The shares are sold in the public market, where – if all goes well – they do, in fact, lose value. The investor then buys the shares back in the open market at the lower price, and returns the borrowed shares to the broker. After paying related fees and interest, any amount that remains is profit.

Can You Short Any Stock?

When you approach your broker to short a stock, you may be told that shares in certain companies or in certain categories are not eligible. Because of the risk involved in short selling, both for the investor and the broker lending the shares, many firms have set guidelines on the types of short sales they will support.

These aren’t requirements set by the SEC (Securities and Exchange Commission) or FINRA (Financial Industry Regulatory Authority). Instead, the firms base their requirements on their strategy for avoiding excessive risk. That means that stocks available for short selling can vary from brokerage to brokerage.

Some restrictions are often found across brokerages. For example, one of the most common restrictions is refusal to permit short sales of stocks that are already low-priced – for example, $5 per share and under.

What Happens if You Short a Stock and It Goes Up?

The biggest risk involved in short selling strategies is that losses are theoretically unlimited. If an investor borrows shares and sells them, then share prices increase dramatically, the investor must cover the difference to buy back and return borrowed shares.

Compare this to a “buy low, sell high” approach. In a traditional trade, an investor may purchase shares at $50 each. Over time, the shares may increase to $100 each or more.

Profit potential is virtually unlimited, and the investor can pocket the difference between purchase price and current price at any time. If prices drop, the maximum loss is the amount of the original purchase.

For example, in the year 2000, investors bought Amazon [NASDAQ: AMZN] for $60 – $70. Today, those same shares are worth more than $2,300 each. Though there have been ups and downs, the most any Amazon investor could lose was the original purchase price. That is not so with short selling.

When you short stocks, you face the exact opposite scenario in terms of risk versus reward. If share prices go down as you predict, the most you will gain is the difference between your original sale price and the buyback price.

Conversely, if share prices increase significantly, you are responsible for the difference between your sale price and the new higher price you must pay to repurchase and return the borrowed shares.

What is a Short Stock Example?

The following example illustrates how a short sale works:

• The brokerage holds shares of XYZ stock.
• You have an open margin account.
• You borrow 100 shares of XYZ stock from your brokerage.
• You sell the 100 shares in the public market at their current price of $50.
• Share prices drop to $25 each.
• You buy back the 100 shares at $25 each.
• You return the 100 shares to your brokerage, plus any related fees and interest.
• You retain the difference of $25 per share.

Again, this can be a risky strategy, as your predictions for a drop in value may not be accurate. This is the alternative:

• You borrow 100 shares of XYZ stock from your brokerage.
• You sell the 100 shares in the public market at their current price of $50.
• Share prices increase to $55 each.
• You buy back the 100 shares at $55 each.
• You return the 100 shares to your brokerage, plus any related fees and interest.
• Your loss is the difference, or $5 per share.

The most you can gain is the difference between the sale price and $0. However, if share prices increase to $60, $100, or more, you could be facing substantial losses. This strategy can be effective, but it should be used with care by experienced investors.

How to Short a Stock with Options

There is more than one way to profit when you expect a certain stock to decrease in price. Rather than borrowing shares, selling them, and buying them back as you would with the standard short-selling process, you can short a stock with options. Specifically, you can use call and put options to create what is known as a “synthetic short position”.

The strategy works like this: you can purchase a put option, which is the right – but not the obligation – to sell specific shares at the price listed in the option (strike price) by the date identified in the option.

At the same time, you can sell a call option, which gives the purchaser the right – but not the obligation – to buy specific shares at the price listed in the option (strike price) by the date identified in the option. Both of the options carry the same strike price and the same date.

If the share price of the specified stock goes down, the value of your put option increases.

Conversely, if the share price of the specified stock goes up, the value of your put option falls and the value of the call option increases. That leaves you with an obligation to cover the difference in share price, which presents the same sort of risk that you face with a standard short sale.

Most brokerage accounts, including popular online services, offer an opportunity to trade options. While options-based strategies are certainly more complex than straightforward stock trades, they offer intriguing opportunities to build your wealth. For that reason, they are worth exploring.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.