Why Options Can Be a Safer Bet than Short Sells

I recently had lunch with a friend of mine who I describe as a pure speculator when it comes to trading. We were talking about the recent weakness of the DOW and the NASDAQ. He mentioned he was planning to short the DOW, as he expected it to fall to 10,000. An interesting idea, but I had a better plan.

 I suggested to him that he may want to consider buying put options or a bearish call spread rather than shorting. While not totally convinced of this, he asked me why I did not like shorting. I told him that I do like to short in the right situation, but in times like these I prefer to have manageable risk.

 When compared to short selling, put options require less upfront money and entail far less risk. Let’s take a look at Cisco Systems Inc. (CSCO). To short 100 shares of CSCO at the current price of $17.17, the required initial margin requirement is 50% on the short position, or $2,575.50 (150% x $17.17 x 100 shares). This is  the money you put at risk, as shorting involves unlimited risk.

 Alternatively, let’s say you believe Cisco will decline by April 2006. You can buy the in-the-money Cisco April 2006 $17.50 Put option for a premium of $125 for one contract (which represents 100 shares of Cisco). The $125 is also the maximum risk — with short selling, on the other hand, you could lose an unlimited amount since the price of the stock could rise indefinitely in theory.

 In my view, put options represent a more prudent overall bearish strategy than short selling. Here’s why.

 A short seller simply borrows a particular stock that he or she does not 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 problems start when the short position goes against you and the stock rises instead of falls.

 For example, say you had decided to short Cisco and placed a short on 100 shares at $17.17. Now let’s assume the price of Cisco rallies to $25 by April 2006. At this price, you would have to short cover by repurchasing the 100 shares of Cisco at the much higher $25 in the open market and returning the shares to the holder. You would end up losing over about $783. Compare this to the buyer of the April 2006 put option who would have lost only the $125 premium.

 The reality is that short sellers are subject to unlimited risk. The greatest risk is in momentum-driven markets. In today’s market, except for a few select cases, I’d go with options.