How to “Short Sell” Without the Risk and High CostsIt isn’t a hidden fact that investors can make money when stock prices go down. One way to do this is by shorting shares of companies that investors believe won’t perform well because profits will be lower, sales will be stagnant, and so on and so forth.
No doubt, short selling is beneficial when stock prices are falling, and it certainly lets investors make money; however, if the stock prices go in the opposite direction, investors can be in for a long period of misery—their losses can even be more than 100%. In addition, in order to short, investors need to meet a certain amount of capital requirement in their portfolio.
Instead of just short selling a stock and putting up the capital, thereby exposing themselves to greater risk, investors can make money when the stock price is falling by using an option strategy called the “bear put spread.” This option strategy provides investors with a limited-risk, low-capital option.
Consider this: Google Inc. (NASDAQ/GOOG) trades well above $700.00. To simply short 100 shares of this company, investors require a significant amount of capital.
At the very core, a bear put spread requires investors to buy a put option strike price above the current stock price, in anticipation of stock prices falling, and a write/sell put option at a lower cost than the current stock price. One key aspect investors must remember is that these two put options should have the same expiry date.
Suppose ABC, Inc. is trading at $30.00 per share now, but an investor believes that the stock price will decline. So, instead of short selling, he/she decides to use the bear put spread option strategy. Now, suppose the investor purchases a put option strike price expiring in May for $300.00, and a write/sell put option at a strike price of $25.00 expiring in May for $150.00.
If the price of ABC’s shares drops to $24.00, the put options will at least have a value of $600.00 and the put options sold will have a loss of $100.00, resulting in a profit of $350.00 after taking out the costs ($600.00 minus $100.0 [loss on put sold] minus $150.00 [cost of buying put option minus cost of selling it]).
In this option strategy, the investor achieves the maximum profit when the price of the underlying security is similar to the price or less than the strike price of the put option written/sold. From our example above, if the price of the stock is below $25.00, the investor will earn the maximum profit.
Likewise, maximum loss occurs when the price of the underlying security is greater than or equal to the strike price of the put options purchased. In our example above, if the price of the stock is above $30.00, investors will face a loss.
Despite all the benefits, such as how it bypasses investors to have certain capital requirement and provides limited risk, this option strategy has one setback, as well—an investor’s ability to earn profit is limited.
To make money in the stock market, investors don’t really have to always use conventional investment strategies. If they explore a little further, investors can minimize their risks and grow their portfolio significantly over time by using alternative investment strategies—the bear put spread being one.
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