Hedging a Short Position With Options

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Hedging a Short Position With Options

Short selling may be a dangerous business, but the inherent risk of a short position can be considerably reduced by using options. One of the most compelling reasons against short selling in the past was the possibility of limitless losses. Options allow short sellers to hedge their holdings and reduce their losses if prices suddenly rise.

Key Takeaways

  • A short stock position may be hedged by purchasing a call option.
  • The use of options to hedge a short position reduces losses.
  • This method has numerous downsides, including time decay losses.

The Biggest Risk

The most significant risk of a short position is a price increase in the shorted stock. A jump like this might happen for a variety of reasons, such as an unexpected good event for the company, a short squeeze, or an increase in the larger market or industry. This risk may be minimized by hedging the risk of a rapid advance in the shorted stock using call options.

If you do not hedge a short stock position using call options, you risk losing all of your money.

How Hedging a Short Position With Options Works

Shorting the stock and purchasing the call is a relatively simple option strategy. Shorting a stock in the traditional method is the first step. At the same time, the investor acquires a call option. The call offers the investor the right to purchase the shares at a certain price and time period. Because a short seller must ultimately buy back the stock that was shorted, the call option restricts how much the investor must spend to acquire it back. Purchasing a bear put spread is a little more sophisticated option to this method.

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How To Protect A Short Position With Options

An Example

Assume you are short 100 shares of Big Co. while the stock is trading at $76.24. If the stock increases to $85 or higher, you will face a significant loss on your short position. As a result, you purchase one call option contract on Big Co. with a strike price of $75 expiring in a month. This $75 call is now priced at $4, so it will set you back $400.

If Big Co. falls to $70 during the month, your short position gain of $624 ([$76.24 – $70] x 100) is reduced by the $400 cost of the call option, for a net gain of $224. We’re presuming that after a month, the $75 calls are worth close to nothing. In actuality, if there remain a significant number of days to expiration, it may be feasible to recover some value from the calls.

The true value of utilizing a call to hedge your short position in Big Co. becomes apparent when the stock climbs rather than falls. If Big Co. rises to $85, the $75 calls will be worth at least $10. Thus, your short position’s loss of $876 ([$76.24-$85] x 100) would be offset by your long call position’s gain of $600 ([$10 – $4] x 100), for a net loss of $276.

Even if Big Co. reaches $100, the net loss will remain pretty constant at $276. The short position’s loss of $2,376 ([$76.24-$100] x 100) would be compensated by a gain of $2,100 ([$25 – $4] x 100) on the long call position. This is because the $75 calls would be worth at least $25 if Big Co. reached $100.

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The Drawbacks

The use of calls to hedge short stock positions has a few downsides. For starters, this technique is only applicable to equities with options. Unfortunately, it cannot be employed when shorting small-cap companies with no alternatives. Second, purchasing the calls is an expensive proposition.

More crucially, the calls’ protection is only accessible for a short period. Every call option has an expiry date, and longer-dated options are obviously more expensive. In general, time decay is a critical issue for any strategy including the purchase of options. Finally, since options are only available at specified strike prices, an unsatisfactory hedge may arise if the call strike price differs significantly from the price at which the short sale was executed.

The Bottom Line

Purchasing a call and shorting the underlying stock is a much safer method to be a bear. Despite its downsides, utilizing calls to hedge a short position may be a useful technique. A trader’s earnings may actually grow in the best-case situation. If the shorted stock falls sharply, the investor may exit the short position early. If the investor is really fortunate, the stock will then recover. In such situation, the call options that were unprofitable to sell while the stock was falling may have turned a profit in the end.

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