Prefer Manageable Risk

I had lunch with a friend of mine who I describe as an aggressive speculator when it comes to trading. No pain no gain is his trading motto, which has gotten him in a lot of trouble in the past. Anyhow, we were discussing the strong buying in the markets. He mentioned he was planning to short the DOW as he expected it to fall to 11,600 sometime in 2007. In response, I suggested t o 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. It is not that I do not favor shorting as it makes sense in certain situations, but I prefer to have manageable risk.

 Versus 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 $27.02 as at November 28, the required initial margin requirement is 50% on the short position, or $4,053 (150% x $27.02 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 July 2007. You can buy the in-the-money Cisco July 2007 $27.50 Put option for a premium of about $220 for one contract (equals to 100 shares of Cisco). The $220 is also the maximum risk, whereas, you could lose an unlimited amount via short selling since the price of the stock can rise indefinitely in theory.

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

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 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 problem is if the short position goes against you in that the stock rises instead of falling.

 For example, say you had decided to short Cisco and placed a short on 100 shares at $27.02. Let’s assume the price of Cisco rallies to $33 by July 2007. At this price, you would have to short cover vis-à-vis repurchasing the 100 shares of Cisco at the much higher $33 in the open market and returning the shares to the holder. You would end up losing over about $598. Compare this to the buyer of the July 2007 put option who would have lost only the $220 premium.

 The reality is short sellers are subject to unlimited risk since a stock price in theory can move up infinitely. The greatest risk is in momentum-driven markets.

 Note that short selling has more downside potential than put options, but the limited risk of put options far outweigh the extreme losses that short selling can generate.