Option Investor

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"Shorting" Stock to Cover a Sold Put

One of our readers asked about using this strategy when a "naked" put position goes awry. In fact, there are a number of common methods to exit or cover a losing trade that involves a short put and they range from simply closing the play for a loss to rolling into a long-term calendar (time) or credit spread. However, another technique has merit for more experienced traders; covering (by shorting the stock) the sold put option as the stock moves through its strike price. This is a great method for exiting the position when the underlying issue has reversed its primary trend, but you must be prepared to repurchase the stock in the event of a recovery.

The first subject that must be clearly understood is short selling or "shorting" a stock. In general terms, selling short is a less common technique whereby a trader seeks to sell high and buy low; the reverse of what most investors try to do. To participate in this strategy, an investor sells borrowed stock in anticipation of a drop in price. A broker supplies the stock in a loan to your margin account. If the stock falls below the price at which it was sold, it is repurchased and eventually returned to the broker as a replacement for the stock that was originally borrowed. The profit is the difference between the sale price and the purchase price. While this technique may seem easy, short selling is one of the most misunderstood of all types of securities transactions and is often considered unscrupulous. But, when properly executed, selling short can preserve capital and be very profitable, and it also a necessary element of position management for option traders as well as an essential hedging component for market-makers and exchange-floor specialists.

The most common use of the strategy with retail option traders involves selling the underlying stock to hedge or cover losing positions that include short puts. The put writer is "covered" if there is a corresponding short position in the underlying stock, or its equivalent, in his account. If the sold put is exercised, and the stock is delivered, it can be further assigned to replace the previously borrowed equity. Remember, a "short sale" is the sale of a security that is not owned. The investor borrows the stock, through a broker, and then sells it in the open market. When the sold put is assigned, the investor is forced to purchase the stock, which he eventually returns to the broker, replacing the borrowed position. The problem with this technique is the potential loss can be substantial when the share value of the underlying issue rebounds above the initial short price and you do not repurchase the stock in a timely manner. If the issue remains above the strike price of the sold put, it will not be assigned and the trader will be forced to buy the stock in the open market, at the current price, to fulfill his obligation. The absolute necessity of protective trading stops is obvious in this strategy. With a buy-stop order on the stock, the chance of a potential loss in the (recovery) position is much lower if the price of the stock moves significantly higher than the strike price of the sold put. It is generally recommended that the trader place a buy-stop order for the (sold) stock slightly above the strike price of the short option, to protect against unexpected rallies or trend reversals.

The risks of short selling are many but the most obvious problem is that when you are short, the potential loses are infinite. Short-sellers lose when the stock price rises and a stock is not limited on how high it can rise. Because short-selling involves margin (borrowed money), it's very easy for losses to get out of control and traders must maintain adequate collateral in their portfolio at all times or they will be subject to a margin call. Traders who short stocks are also subject to strict operational rules. All short sales must be made in a margin account, usually with stock borrowed from another customer of the brokerage firm, and the collateral requirements are similar to stock ownership. If the stock is in demand among short sellers, a trader may have to pay a premium for borrowing it. In addition, all dividends on the stock must be paid to the current owner and as a borrower, you are not entitled to any rights or benefits of ownership.

Covering a short put with the sale of stock is a common method for offsetting potential losses in option positions, but it is not appropriate for everyone. However, in a bearish market, the technique offers a favorable "rescue" strategy if the issue has little chance of finishing the expiration period above the strike price of the sold put. For more information on basic option trading strategies, read Options as a Strategic Investment, by Lawrence McMillan and Option Volatility and Pricing Techniques, by Sheldon Natenburg, both available in your local library.

OW Staff

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