Aug 18 2008
Taking the Short Plunge
Like Slim Pickens in Dr. Strangelove, shrieking while riding an H-Bomb as it plunges down to its point of nuclear detonation, some crafty option traders take a similar plunge when riding the misfortune of some stock as its price plunges down. But traders shriek for joy and not fear from becoming extra crispy but because the intrepid trader is making money. Being in position to ride a plunging stock can be a thrilling and profitable strategy for nimble option traders.
Once a stock “breaks down”, there can be a stampede for the exits and this helps create a sudden and usually exaggerated fall in price. As a result of the hysteria, shorting a stock can normally produce higher profits in a shorter period of time.
It seems to be a natural mindset for traders and investors to constantly think about upside potential much more often than downside profit potential. Maybe it’s the paradox of something decreasing in value but at the same time increasing in value. But when analyzing the mechanics of going short and how a profit is made can clear things up.
When shorting a stock, a trader will borrow the stock from the broker at a certain price and then hope to sell the stock back to the broker at a lower purchase price…..but the broker has to re-purchase the stock back at the original price when the stock was lent to the trader. In reality, the trader sells the stock back to the broker for the price it was borrowed but the trader can go into the market and purchase the stock at a lower price (after it has gone down) and make a profit on the difference between the price it was borrowed for In effect, it is the same thing as buying low and selling high.
For an option trader, there are several ways to make money from a declining stock. Perhaps the most simple is to purchase a put. The risk is limited to the put premium no matter what happens to the stock. Another strategy is to set up a straddle where a put and a call are purchased at the same strike price. This helps protect against an unforeseen reversal. The risk is limited to the total cost of the put and call. Yet another strategy is to short the stock and protect against an upside move by purchasing a call.
When using any short strategy, the trader must be nimble as most down breaking stocks are usually an overreaction as fear takes over and exaggerates the movement. Usually, when the fear subsides a bit, buyers start to creep back in and the price starts to rebound. For this reason, short players need to be quick on the trigger to take profits.
In some stock option strategies, writing naked puts can be part of the strategy, and this can be dangerous. As mentioned, stocks in a down break move rapidly and if a put is written without protection, the writer of a naked put may have to go into the market to cover an assignment and may pay heavily for the stock. Therefore, anytime a put is written, it is a good idea to have it hedged either with the purchase of an out-of-the money put or the stock itself.
For more information on the fantastic world of stock options, check out Options University (www.optionsuniversity.com) for a range of online courses, web casts, and seminars.
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