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Playing the Downside
by Jon Najarian

How I Trade Options One of the clearest examples of why it’s better to use options instead of dealing with shares directly is playing the “short side”. Admittedly, there are many professional traders and “vulture funds” that make money by shorting stocks that they believe are going to decline in value. When you short a stock, in effect, you’re agreeing to sell shares at a certain price – say $10 a share – even though you don’t really own the stock, because you believe the price is going to decline and you’ll be able to deliver those shares later at a lower cost – say $8 a share.

Many retail customers think it is “un-American” to short a stock. They want share prices to go up; that’s why they buy a stock. They don’t want to think about stocks that might decline in value. But day-traders – particularly professional ones – know differently. They play the stock market from the short- and the long-side. But to do that, you have to literally borrow the shares of a stock that you want to short until the time that you can deliver the securities for which you are obligated.

Problems may arise, however, if you need to “borrow” a stock that has a very thin float, meaning there are only a few shares out-standing. In such a situation, a majority of the shares are in the hands of company “insiders” and institutions. Perhaps only 15 to 20 percent of the total shares are in the hands of the public, whereas 80 to 85 percent of the float is held by company insiders and institutions.

With only a few shares around to “borrow”, it may be difficult – and potentially very costly – to short the stock, adding to your overall risk. As you’ll see, an easier way to play the short side would be to invest in put options. But first, let’s discuss how the stock-shorting scenario would play out.

You believe that Company XYZ shares are over-valued. If you actually owned the stock, it might be a good time to sell. But what if you didn’t own the stock? One possibility would be to short the stock. When you short a stock, your brokerage firm has to go out and borrow stock certificates electronically. Remember, every time shares are bought and sold, these certificates have to be sent to the buyer. Instead of Brinks trucks full of stock certificates going to and fro, today it’s all done electronically. But, these stock certificates still have to change hands, they just do so with the click of a mouse.

If you’re shorting a stock, certificates also have to change hands. However, the process is far more complicated than a simple sale. When you short the stock, you’re promising to sell something you don’t already own.

Here’s how it works: First the short-seller commits to sell 100 shares of XYZ at a certain price, say $100 share. In this scenario, the short-seller believes the shares are currently over-valued and will be available for purchase in a few days or a few months at a lower price. Once the commitment is made, the seller then has three days to settle the transaction. That means that the seller needs to fulfill the obligation to deliver to the buyer stock certificates in three days. The seller’s clearing firm normally goes out and borrows the stock certificates from someone who owns the stock – often a larger brokerage or financial institution. But, those lenders don’t loan out their stock certificates as a “favor”. It’s often a very lucrative transaction.

The brokerage or institution that agrees to lend the stock is already charging some customer margin on the shares. For example, if 100 shares of XYZ are priced at $100 a share, you would need to come up with $10,000 or $5,000 on margin. In return for putting up that $5,000 on margin, the brokerage firm will charge an interest rate anywhere from 6 percent for a major trader to 12 percent for a smaller investor.

That margin interest is just part of the money the brokerage stands to make if they can lend the shares to a short-seller. The brokerage firm also earns interest on the proceeds of the short sale. A large trader who makes a short sale collects the bulk of the interest on the sale proceeds, often 90 percent of the interest, while the brokerage firm that loaned the stock certificates collects the other 10 percent. A smaller professional trader may keep 70 percent of the interest, while the brokerage gets the other 30 percent. While a retail investor who chooses to play this risky game may get zero interest, while the brokerage keeps it all. (That interest on the proceeds of a short sale is in addition to whatever margin the brokerage house may also charge. Margin and interest are some of the most lucrative businesses for brokerage firms.)

The most dangerous thing that can happen when you sell a stock short is what’s known as a “short squeeze”. That usually occurs when the lender demands the stock back. The short-seller then has no choice but to go to the market and buy shares at the prevailing market price. If the short-seller doesn’t do it, the lender will do it – perhaps at not the most competitive of prices. Take it from me, every time a firm has bought me in on borrowed shares, they paid the high of the day.

In options, we can usually tell when there’s a short squeeze on a stock because the puts become very inflated. The pricing model may show that a put should be trading at $6 a share; instead, it’s at $10. The reason is either a short squeeze in the stock or a back-end on a takeover deal. In either case, protection seekers or arbitrageurs, they’ll pay anything for the puts.

When there’s a short squeeze on a stock, you face considerable risk of the share price rising sharply – the exact opposite of what you’d hoped would happen when you shorted the stock. (Remember, in this scenario the short-seller committed to sell 100 shares at $100, hoping that the share price would decline, enabling shares to be purchased at a lower price – say $90 or $80 a share – to replace the borrowed certificates.) You might even be right about the stock; it is over-valued and shares will eventually drop. But in the meantime, you could get caught in a short squeeze.

A far better way to play a price decline in a stock is to buy put options. If you think a $100 stock is over-valued, you can buy puts with a strike price of $100, $95, $90, or lower. (Remember, the farther an option is “out-of-the-money” the less premium you’ll have to pay). If the stock doesn’t go down as you expect, all you’ll lose is the premium. But if you short the stock and the market goes against you, your potential loss is almost unlimited. Put another way, if you short sell 10,000 shares and the price goes up by $3, you are facing a $30,000 loss.

 
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