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Short selling can be a risky endeavor, but the inherent risk of a short position can be mitigated significantly through the use of options.

The biggest risk of a short position is that of a price surge in the shorted stock. Such a surge could occur for any number of reasons, including an unexpected positive development for the stock, a short squeeze, or an advance in the broader market or sector. This risk can be mitigated by using call options to hedge the risk of a runaway advance in the shorted stock.

For example, assume you short 100 shares of Facebook, Inc. (FB) when the stock is trading at $76.24. If the stock rises to $85 or beyond, you would be looking at a substantial loss on your short position. Therefore, you buy one call option contract on Facebook with a strike price of $75 expiring a month from now. This $75 call is trading at $4, so it will cost you $400.

If Facebook declines to $70 over the month, your gain of $624 on the short position ([$76.24 - $70) x 100) is reduced by the $400 cost of the call option, for a net gain of $224. We are assuming here that the $75 calls are trading at close to zero, but in reality, you may be able to salvage some value from the calls if there are a considerable number of days left to expiry.

The real benefit of using a call to hedge your short Facebook position, however, would be evident if the stock rises appreciably, rather than declines. If Facebook advances to $85, your $75 calls would trade at a minimum of $10. Thus, the loss of $876 on your short position would be offset by the gain of $600 ([$10 - $4] x 100) on your long call position, for a net loss of $276. Even if Facebook soars to $100, the net loss will stay relatively unchanged at $276, as the loss of $2,376 on the short position would be offset by a gain of $2,100 ([$25 - $4] x 100) on the long call position. (Note that the $75 calls would trade at a price of at least $25 if Facebook was trading at $100.)

There are a few drawbacks of using calls to hedge short stock positions. Firstly, this strategy can only be employed for stocks on which options are available, so it cannot be used when shorting small-cap stocks on which there are no options. Secondly, there is a significant cost involved in buying the calls. Thirdly, the protection offered by the calls is only available for a limited time, i.e., until their expiration. Finally, since options are only offered at certain strike prices, an imperfect hedge may result if there is a large difference between the call strike price and the price at which the short sale was effected.

The Bottom Line

Despite its drawbacks, the strategy of using calls to hedge a short position can be an effective one. In the best-case scenario, a trader can increase profits if the shorted stock drops suddenly and then rebounds, by closing out the short position when the stock declines and then selling the calls when they increase in price.

Disclosure: The author did not hold positions in any of the securities mentioned in this article at the time of publication.

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