These are difficult and erratic times for the markets. The DOW fell a hefty 387 points, or 2.83%, on August 9. The selling pressure had driven down the DOW over five percent since trading at over 14,000 on July 16. The DOW has seen a minor correction, and there could be more weakness in the near term as market breadth and sentiment indicators are weak, although the selling has created a technically oversold condition and the potential of near-term buying support. Some of you may be looking to short the market. Due to the enormous risk involved, I don’t advise this strategy for the average investor. Instead of shorting the market or specific stocks, I suggest you look at buying put options or initiating a bearish call spread. The major advantage of put options over shorting is that you know from the start the maximum risk you will be subject to with options.
Versus short selling, put options require less up-front money and entail far less risk. Let’s take a look at Google Inc. (NASDAQ/GOOG). To short 100 shares of Google at the current price of $515.46, the required initial margin requirement is 50% on the short position, or $77,319 (150% x $515.46 x 100 shares). This is the money you put at risk, since shorting involves unlimited risk because, in theory, the price of the stock can rise indefinitely. The greatest risk lies in momentum-driven markets.
Alternatively, let’s say you believe Google will decline by December 2007. You can buy the out-of-the-money Google December 2007 $520.00 put option for a premium of about $3,600 for one contract (which equals 100 shares of Google). The $3,600 is the maximum risk.
In my view, put options represent a more prudent bearish strategy than short selling. Here’s why:
A short seller simply borrows a particular stock that he or she doesn’t own and sells it in the market at the prevailing price. For the strategy to pan out, the short stock must drop in price so that the short seller can buy it back at a lower price and replace the borrowed position to the registered holder. The risk is that the stock could rise in price instead of fall.
For example, let’s say you had decided to short Google. You placed a short on 100 shares at $515.46. Let’s assume the price of Google rallies to $600.00 by the expiry of December 21, 2007. At this price, you would have to short cover by repurchasing the 100 shares of Google at the higher $600.00 price in the open market and return the shares to the holder. You would end up losing about $8,400. Compare this to the buyer of the put option who would only lose a $3,600 premium in the same scenario.
In my opinion, the limited risk of put options far outweighs the extreme losses that short selling can generate.