Use options to hedge short positions

Short selling may be a risky attempt, but the inherent risks of short positions can be significantly reduced by using options. Historically, one of the most convincing arguments against short selling is the possibility of unlimited losses. Options provide short sellers with a way to hedge their positions and limit losses in the event of unexpected price increases.

Key points

  • You can hedge short stock positions by buying call options.
  • Use options to hedge short positions to limit losses.
  • This strategy has some disadvantages, including losses due to time decay.

Biggest risk

The biggest risk of a short position is the price of short stocks soaring. There are many reasons for this surge, including unexpected positive development of stocks, short squeeze, or a rise in the market or industry. This risk can be reduced by using call options to hedge against the risk of uncontrolled rise in short-selling stocks.

If you do not use call options to hedge short stock positions, you may lose an unlimited amount of money.

How to use options to hedge short positions

With the development of options strategies, it is very simple to short stocks and buy call options. First short a stock in the usual way. However, investors also bought call options. Call options give investors the right to buy stocks at a specific price within a specific period of time. Since short sellers must eventually repurchase the short-sold stocks, call options limit the fees that investors must pay to retrieve the stocks. A more complex alternative to this strategy is to buy a bear market put spread.

How to use options to protect short positions

one example

For example, suppose you go short when the trading price of 100 shares of Big Co. is $76.24. If the stock rises to $85 or higher, you will face a significant loss in your short position. Therefore, you purchased a Big Co. call option contract with a strike price of $75, which expires one month from now. This $75 call option trades at $4, so you will spend $400.

If a large company drops to $70 that month, your short position gain is $624 ([$76.24 – $70] x 100) Subtracting the call option cost of $400, the net benefit is $224. We assume here that the $75 call option will trade close to zero one month later. In fact, if there are a considerable number of days to expire, it is possible to save some value from the call.

However, when stocks rise rather than fall, the real benefit of using call options to hedge your short positions in large companies becomes apparent. If Big Co. rises to $85, then the $75 call option will trade at least $10. As a result, $876 was lost ([$76.24-$85] x 100) of the short position will be $600 ([$10 – $4] x 100) long bullish position with a net loss of $276.

Even if a large company soars to US$100, the net loss will remain relatively unchanged at US$276. Loss of $2,376 ([$76.24-$100] x 100) of the short position will be $2,100 ([$25 – $4] x 100) On a long bullish position. This happens because if Big Co. reaches $100, the trade price of a $75 call option will reach at least $25.

shortcoming

There are some disadvantages to using call options to hedge short stock positions. First, this strategy only applies to stocks with available options. Unfortunately, it cannot be used to short small-cap stocks without options. Secondly, buying a phone involves a lot of costs.

More importantly, the protection provided by the call is only available for a limited time. Every call option has an expiration date, and options with longer maturities will naturally cost more money. Generally speaking, time decay is the main issue for any strategy that involves buying options. Finally, since options are only offered at a specific strike price, if there is a large difference between the call strike price and the short sale price, it may lead to imperfect hedging.

Bottom line

Buying call options and shorting stocks is a safer way to go short. Despite its shortcomings, the strategy of using call options to hedge short positions may be an effective strategy. In the best case, traders can actually increase profits. Assuming that the short-selling stocks suddenly fall, investors can close their short positions in advance. If investors are particularly lucky, the stock will rebound. In this case, call options that are not worth selling when the stock falls may eventually make a profit.

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