Short Selling

The Smart Profits Report: Issue #277
Tuesday, January 24, 2006

Short Selling - Beating the Government By Going Short
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

I don’t always appreciate government regulations. Many are burdensome and unnecessary. But I accept why the rules governing Individual Retirement Accounts and most pension accounts prohibit short selling. In theory, when selling short, your gains are limited while your losses are unlimited.

That can be a fool’s choice if you don’t know how to make money from stocks that are struggling. It also means that if you want to make money in your retirement account from a declining or volatile market, you need to know how to use put options. This “derivative” can be tricky. It uses a completely different set of rules than a stock or mutual fund.

Okay. So you’ve decided that a company’s stock is heading south. Its exports are off, new opportunities for growth are stymied and marketing is flat. What to do? Buy a put, right?

Well, yes. But what put? And when?

Don’t Be Fooled By That Sexy Price Tag

The potential problem here is that many novices buy at- or out-of-the-money short-term puts, which means that not only do they have to be right about the direction of the underlying stock, but they also have to know how long it will take to reach their price objective. That’s option buying with a crystal ball.

Most of the option volume on a particular stock takes place at- or just-out-of-the-money. These are usually lower-priced options, with a hefty time premium, that are bought and sold by speculators and novices who are looking for a lot of leverage and a big score.

But why get hemmed when you can give yourself a fair chance to come out ahead?

I’ve developed a technique over the past 10 years for my clients’ retirement accounts that produces just about the same results and has a slightly lower risk than a short sale. It also mitigates the common problem of time erosion that most options carry.

Let me show you how it works…

When Google Plunges, Your Short Option Will Multiply

If you look at an option chain, you will find that the options that are deep in the money carry virtually no time premium, even ones that expire months down the road.

I’ll use Google (Nasdaq: GOOG) and the June 2006 puts as an example because Google has a high price and high volatility. And the June expiration gives us a sizable time premium.

On Friday, January 13, 2006, GOOG closed at $466.25. Let’s say that you thought GOOG would drop to $400 over the next few months. In a regular account, you can execute a short sale at $466 in your margin account and your requirement (what you’d have to come up with) would be $233 per share. Once executed, you’d put in a stop loss order (we’ll use $500 for this example) and forget about it.

But in a retirement account, you are forced to use the options market in order to benefit from a drop in GOOG shares.

Most investors, especially ones without much option experience, would look at the June 2006 puts with a strike price around $460 or lower. The GOOG June $460 put closed at $40, which is a $46 time premium that equals 10% of the value of the underlying stock. That means that GOOG would have to drop $46 (about 10%) just to break even.

That’s too much, so let’s take a look deeper into the option chain.

The GOOG June $650 put closed at $185, which means that the time premium is just $1 per share ($650-$185= $465), and to break even, the stock only needs to drop $1 (2/10 of 1%). More importantly, the option will move dollar-for-dollar with the price of GOOG.

Using a deep-in-the-money put such as this creates a “synthetic short sale” because, like short selling, this option offers a reward when the underlying stock drops. But, if used properly, the deep-in-the money put offers more protection against losses.

The important point is that choosing the right time element is as important as selecting the right put option. I’ve used this technique to give myself a better opportunity to profit… there’s no reason you shouldn’t do the same.

Today’s Smart Profits Cribsheet

Check out the Smart Profits Glossary for definitions of words used in the above article like, “short selling” or “option chain.”
We’ve talked about getting the best price for a put option. Fellow Mt. Vernon Research Advisory Panelist, Lee Lowell, illuminates us on using the battle-axe of the financial world: leverage. Lee explains how to apply one of the most intelligent - and profitable - ways you can invest your money. For all the details, see Smart Profits #262, Options Leverage - How to Use Delta to Maximize Leverage.
Find out what 99% of brokers are really thinking when you ask them about trading options… Karim Rahemtulla, Chairman of Mt. Vernon Research, has a few must-read notes if you’re just getting started with these investment vehicles. Smart Profits #232 and #233 comprise Karim’s two-part series, Secrets to Getting Started In Options.