Should You Use Options to Go Short?

As part of our special series on short-selling, Fool contributors Anders Bylund and John Del Vecchio debate whether using options is smarter than selling stocks short.

Anders Bylund
"You know I'm born to lose, and gambling's for fools,
But that's the way I like it, baby,
I don't wanna live forever!"
-- From "The Ace of Spades," by Motorhead, 1980

Options contracts can help you make money on negative bets -- without losing your shirt. Don't invest like Lemmy Kilmeister, quoted above.

The market is full of overvalued stocks. Apple (Nasdaq: AAPL  ) is a fine company, but the stock is too expensive unless Steve Jobs really can walk on water. Blockbuster (NYSE: BBI  ) is losing its eternal multi-front war against Netflix (Nasdaq: NFLX  ) and could soon join Movie Gallery in that great video store in the sky. RadioShack (NYSE: RSH  ) has officially given up and is looking for a buyer; what if it can't find any interested partners? And the list goes on.

Faced with such a rich list of overpriced stocks, your short-selling trigger finger might be twitching. You'd be in fine company, too: 8% of RadioShack's float was sold short as of May 14, while 21% of Blockbuster's shares are waiting for the goose egg. The market really seems to think that Netflix has gotten ahead of itself -- the short share there is 27.5%.

Go ahead and place your bets, if that's your thing. But I'll tell you why I will never again sell a stock short, though. You see, it really is a bet -- and like all gambles, the risks involved are massive.

If you sell Apple or Netflix short, but their stocks continue to climb skyward, there's really no limit to how much money you can lose. The share price triples, and so does your loss. Long-term shorting is insane, because you can't just ride these losses until the tide turns again -- margin calls happen, and they can hurt badly. The upside, however, is limited to a 100% gain -- if the share price goes to zero. In short (ha!), short-selling is a day-trader's game and diametrically opposed to the Foolish buy-and-hold philosophy.

That's where judicious use of options contracts can save the day. Buy some puts on Apple, and the worst that can happen is losing the original investment if the contract expires, worthless. But the upside is magnified many times over; a small dip in Apple's stock price can push put prices up -- a lot. Volatile stocks like Apple and Netflix have volatile options, too. And you can hedge against unwanted swings with refined options strategies. Try that with a short-sale!

John Del Vecchio
Short-selling is a strategy uncommon to the investing public but practiced with regularity in professional investing. As an investor focused on shorting stock exclusively for the past decade, I prefer stock-specific short opportunities rather than using options.

It's true that certain options strategies let you profit when a stock falls in value. Yet, while I am not totally averse to using options, I believe directly shorting stock is preferable for my strategy.

In particular, I have several concerns with buying puts. First, when stocks are topping out, they tend to churn and become more volatile as bulls and bears play tug of war over the stock price. As a result, implied volatility tends to be higher in these scenarios. That makes buying put options more costly, and the "cost of carry" from the strategy is often substantially negative.

While you may be able to control risk by limiting your losses to the cost of the option, you also have to have good timing in selecting the option. If your timing of the expected catalyst to drive the stock lower is off, you'll either suffer a complete loss, or have to roll over your options contract, which can rapidly eat up profits.

Moreover, the options analysis brings into the equation an imprecise valuation model based on historical volatility. Often, the times when you're most inclined to buy puts are when you'll overpay the most for them.

Perhaps most importantly, regardless of what assets you may trade, liquidity should always be a prime consideration. When things go wrong, liquidity always dries up as there is no one around to buy. This results in a price for an asset that may not be reflective of its underlying value and it may be priced much, much lower than its intrinsic worth. Stocks are much more liquid than the options market, and I would much rather have a position in a liquid stock than a derivative of that stock such as a put option.

Whether you're talking about long-term laggards like Eastman Kodak (NYSE: EK  ) or Xerox (NYSE: XRX  ) or dying corporations like Polaroid and General Motors, it's rare for companies to successfully bridge generations. Short-selling lets you take advantage of the natural lifecycle of companies as they give way to newer rivals. That's all part of the system of capitalism.

Have other thoughts on this debate? Tell us about them in the comments below!

Fool contributor Anders Bylund owns shares in Netflix (and he's keeping them), but he holds no other position in any of the companies discussed here. Fool contributor John Del Vecchio has no positions in the companies mentioned. Apple and Netflix are Motley Fool Stock Advisor selections. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 04, 2010, at 3:18 PM, weiwentg wrote:

    John is incorrect - betting against a stock with options allows you to contain your losses far better than if you short the stock. Additionally, depending on whether you believe that volatility on the options is overvalued or undervalued relative to the VIX, you can choose whether to buy a put or to sell a call spread (NOT to sell a single call - that's basically the same as shorting stock and maybe worse because of the leverage).

  • Report this Comment On June 04, 2010, at 8:35 PM, jdvdallas99 wrote:

    Dear Weiwentg,

    Unfortunately, I think a bit was edited out for space reasons (or I just blabber on too much). I initially talked about the VIX as well as how a short seller would actually manage a position in "real life" because the common notion that risk is unlimited and gains are limited is actually bogus. In addition, there's generally a positive carry due to a short rebate. Alas, it didn't make it into the final article. I am not averse to options. I prefer shorting straight stock though and my own performance as a portfolio manager reinforces my personal preference.

    Best,

    John

  • Report this Comment On June 05, 2010, at 6:10 AM, SnapDave wrote:

    John's logic is absolutely correct. However, it is much easier to sleep at night if you are not shorting a stock. I suspect that has something to do with the voting so far. Fear may lead us to do the thing (an option strategy) that is likely to lose more money. At the same time greed would also lead to seeking the magnified returns of options. I'm guilty of both. But I think the fear I experience while shorting a stock may lead me to be less rational about it.

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