Wouldn't the purchase of a put option achieve the same goal as selling short, but with limited risk -- just the cost of the put? Are there any advantages to selling short vs. buying a put? -- Josh Rubin
Puts and shorts are both ways of limiting your losses if a security or the broad market falls.
But if a short goes the wrong way, it can crush you.
column explained the advantages of shorting exchange-traded funds and HOLDRs over sector mutual funds.
But you're right.
If you want to hedge an investment -- that is, limit the amount of money you can lose if the market or a stock turns against you -- buying a put option is by far the better choice. Shorting is for risk-takers who want to profit -- rather than merely limit their losses -- from a down move in the market or a security.
Buying a put option is a simpler transaction than shorting. You also get the added benefit of knowing exactly how much money you can lose in a worst-case scenario. When you short a stock, your potential profits can be greater, but as we'll see, your downside can be unlimited. You can lose all of your investment and then some.
A put is an option that gives you the right to sell a stock or basket of stocks at a specified price (the exercise price) up to a certain date (the expiration date).
Essentially, buying a put is a bet that a security will fall in value. (A call is a bet that a security will rise in value.) If a stock starts to fall dramatically, a put would let you sell that stock at the predetermined price even if the stock continues to fall well past that price. Using a put, you might be able to get out of a stock at 100 even as it plummets to 50.
Here's an example: Say you've profited nicely from owning 100 shares of the
Nasdaq 100 tracking stock
and you are worried the price will soon fall dramatically below its current price of about 114.
You can buy, say, a put with a strike price of 110 and an April expiration. (Options expire on the third Friday of every month.)
Each option represents 100 shares of stock. So that option gives you the right to sell 100 shares of the QQQ at 110 a share by its April expiration date.
If the Nasdaq suddenly goes into a tailspin and the shares fall below 110, you can exercise the option (before it expires) and sell your shares for 110 -- no matter how low the price actually goes.
If the Nasdaq goes up -- great. You get all of the upside, and you don't have to exercise your option. All you've lost is the cost of the option.
Like an insurance policy, the put option is there if you need it, but you don't have to use it.
You'll pay what's called a premium to buy options. "The premium is the price you pay to buy the contract," says Michael Schwartz, chief options strategist at
CIBC World Markets
. The cost of the premium depends on a variety of factors, including the exercise price and expiration date. For example, the later the expiration date on an option, the more you might pay for it because you are paying the seller to carry that risk for a longer period of time.
On Wednesday, the premium on an April 110 put on the QQQ was about 4 1/2. Multiply that number by 100 -- one put equals 100 shares -- to calculate your total cost of $450, plus commissions.
With that put option, you can only lose $400 on your 100 QQQ shares ($4 a share) or $850 including the premium. If the QQQ goes up, you forfeit the premium -- $450 is gone, that's it.
In a short sale, your losses can be unlimited.
When you short, you borrow stock from a broker and sell it into the market with the understanding that the stock eventually will be bought back and returned to the broker. If the stock falls, you can buy it back at a cheaper price and make money.
So if you short 100 shares of the QQQ at 114, the shares fall to 110 and you replace those borrowed shares at that point, you've made $400 minus transaction costs.
But if the QQQ rises to 120, you are out $600 plus transaction costs, and the losses will rise along with the stock price until you bite the bullet and close out your position.
Now let's look at the transaction costs.
To short, you must pay brokerage commissions to sell the stock and buy it back. You also must keep 100% of the proceeds of the short sale with your broker plus an additional amount to satisfy the margin requirement. (When you buy stocks on margin, you're using borrowed money. When you short stocks, you're using borrowed securities. In either case, you have to keep a certain amount of cash or securities with your broker as collateral.)
Any cash in your margin account is sitting idle while your short position is open. As a retail investor, you
won't receive any interest earned on the proceeds of the short sale.
If the short goes against you, you could be required to increase the money in your margin account.
"The only advantage to a short: Time is in your favor," says Schwartz. "There's no expiration on the short." You can, however, be forced to close your short if the broker demands you return the shares you borrowed.
Mechanically, trading options is as simple as buying and selling a stock. Many online brokers offer options trading. And options are available on many exchange-traded portfolios, including the QQQ, the
, Merrill Lynch's
To make sure there are plenty of buyers and sellers, check the "open interest" in the option. Open interest is the number of contracts that have been opened. You would like to have four-digit open interest.
For options prices, volume and open interest, see the
Chicago Board Options Exchange's
Web site at
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Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.