Short selling can be a risky endeavor, but the inherent risk of a short position can be mitigated significantly through the use of options. Historically, one of the most persuasive arguments against short selling was the potential for unlimited losses. Options give short sellers a way to hedge their positions and limit the damage if prices unexpectedly go up.

Key Takeaways

  • It is possible to hedge a short stock position by buying a call option.
  • Hedging a short position with options limits losses.
  • This strategy has some drawbacks, including losses due to time decay.

The Biggest Risk

The biggest risk of a short position is 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.

If you do not hedge a short stock position with call options, it can lose an unlimited amount of money.

How Hedging a Short Position With Options Works

As options strategies go, shorting the stock and buying the call is very straightforward. One starts with shorting a stock in the usual manner. However, the investor also purchases a call option at the same time. The call gives the investor the right to buy the stock at a certain price during a specific time period. Since a short seller must eventually buy back the shorted stock, the call option limits how much the investor will have to pay to get it back. A somewhat more complicated alternative to this strategy would be buying a bear put spread.

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How To Protect A Short Position With Options

An Example

For instance, assume you short 100 shares of Big Co. 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 Big Co. 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 Big Co. 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 after a month. In reality, it may be possible to salvage some value from the calls if there are a considerable number of days left to expiry.

However, the real benefit of using a call to hedge your short position in Big Co. becomes evident when the stock rises instead of declining. If Big Co. advances to $85, the $75 calls would trade at a minimum of $10. Thus, the loss of $876 ([$76.24-$85] x 100) 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 Big Co. soars to $100, the net loss will stay relatively unchanged at $276. The loss of $2,376 ([$76.24-$100] x 100) on the short position would be offset by a gain of $2,100 ([$25 - $4] x 100) on the long call position. That happens because the $75 calls would trade at a price of at least $25 if Big Co. hit $100.

The Drawbacks

There are a few drawbacks to using calls to hedge short stock positions. Firstly, this strategy can only work for stocks on which options are available. Unfortunately, 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.

More importantly, the protection offered by the calls is only available for a limited time. Every call option has an expiration date, and longer-dated options naturally cost more money. In general, time decay is a major problem for any strategy that involves buying options. Finally, since options are only offered at specific 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

Buying a call and shorting the stock is a much safer way to be a bear. Despite its drawbacks, the strategy of using calls to hedge a short position can be an effective one. In a best-case scenario, a trader can actually increase profits. Suppose the shorted stock drops suddenly, then the investor can close out the short position early. If the investor is particularly lucky, the stock will then rebound. In that case, the call options that weren't worth selling when the stock was down might turn a profit in the end.