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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.
"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!