How to Protect an Option Short-Sale at Time of Commitment




Provided By optiontradingstrategies.org

Now let's look at the operation both ways: Let's see what happens if the man is right and the stock declines and if he is wrong and the stock goes up instead of down. If the stock should go down to 30, as the man expects, he covers his stock in the market at 30 and takes his 20-point profit.

A man feels that a stock now selling at 50 will decline and sells 100 shares short in the market. Not willing to risk an unlimited loss if the stock advances, he buys a Call option at 50, good for 90 days, for which he pays $350. He is now guaranteed through the terms of his Call that he can buy 100 shares at 50 at his option before the contract expires, so if he is wrong, his loss will be limited to the cost of his Call option.

Now let's look at the operation both ways: Let's see what happens if the man is right and the stock declines and if he is wrong and the stock goes up instead of down. If the stock should go down to 30, as the man expects, he covers his stock in the market at 30 and takes his 20-point profit. Naturally, he won't want to exercise his Call option to buy stock at 50 because he can buy it better in the market, so he allows his Call option to lapse. He:

Sold 100 shares at 50 - $5,000  
Buy 100 shares at 30 - $3,000  
Buy Call at 50 - $350  
Total Amount Bought - $3,350  
Profit - $1,650  

One might say that he could have made the short-sale without having spent $350 for the protection. Certainly— but suppose that instead of the stock going down to 30, it had gone to 55, 60, 65, and then 70. What then? How far do you let your loss run? Well, some would say, why not sell the stock short and put a "stop loss" order in at 53½?

If the stock declined to 30, he would have saved the $350 and his profit would have been $2,000 instead of $1,650. That's fine, but suppose the stock rose to 54 first, stopped out the man's short-sale with a loss of $350 or $400, and then declined to 30. His original idea was correct—the stock did decline to 30—but the stop-loss order for protection was more costly than the Call option. If he had had the Call option, the rally to 54 would not have worried him because he would have been guaranteed through his contract that he could cover at 50, but the stop-loss order caused him a quick and definite loss.

The Use of a Call Option to Average

Those who remember the market decline in late 1957 and the middle of 1962 recall that people who had bought stocks at high prices before the decline did not have much desire for or even spare funds, for that matter, to try to average their costs by buying additional shares. If a man had bought a stock at 40 and found it selling at 20 a few months later (many stocks did that), he didn't have much incentive to buy additional shares. Had he known the technique of averaging through the purchase of Call options, he might have done well.

Suppose that, after the fall from 40 to 20, the man inquired and learned that he could buy Call options at 20 good for 90 days for $225 per 100-share Call. Now it doesn't take as much nerve—or as much money—to buy a Call for $225 as it would to buy another hundred shares of stock for $2,000. If Mr. Trader (or call him Mr. Investor) had bought such a Call at 20, and before the expiration the stock had advanced to 35, and at that point he sold both the stock that had cost him 40 and the stock that had cost him 20, which he had on Call, his account would look like this:

Bought 100 shares at 40 $4,000
Bought Call 100 shares at 20 225
Bought 100 shares at 20 a/c Call 2,000
$6,225
Sold 200 shares at 35 $7,000
Profit $ 775

On the other hand—and we like to look at both sides-had he not bought the Call, a rise of 35 in the stock would have left him with a 5-point loss on his original stock. Instead, by the additional risk of $225, the rise to 35 gave him the opportunity to come out with a profit.

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