Short Selling Explained
By PAIP Canada staff
After discussing short selling in last weeks’ article, a very informed question came in: Are there any other ways to make money from the decline of a security? And the answer is yes!
In addition to short selling, two additional methods are available to earn a profit from the decline of a security, both involving options.
The first opportunity, and the easiest to grasp, is to purchase a put option. A put option provides the buyer (of the option) the opportunity to sell shares in the given security at a locked-in price should shares decline in value. When purchasing a put option, the cost will be reflective of several factors. If the strike price is set at a price in excess of the current share price, then the option has “intrinsic value”. That means that if it were exercised today, then it would be worth something. Next up is the time value of money which can be a small value, or can be a big number. Depending on the amount of volatility of the stock, how far it is from having intrinsic value, and the time remaining before its maturity, the value of the options can be substantially high, or quite low. The closer the strike price is to the current value of the security, the higher its value. The longer an option has to maturity, the higher its value.
The second opportunity is to sell a call option that is deep in the money. Although difficult to grasp, it shouldn’t take us too long… Remember, you expect shares to decline in value; that’s how you want to make money.
By selling a call option that is “in-the-money” you are essentially offering the buyer the opportunity to purchase shares at a price that’s less than the current market price of the stock – a stock that you do not own.
If you are correct, and the price of the stock declines, then the call option (that you sold) also declines in value. As the seller of the option, the cash inflow occurs when the sale is made. That’s the amount that’s deposited into your account (minus the commissions). The profit is later realized at expiry, when the option expires, and shares trade for a price that is less than the strike price of the option. Potentially, the options could expire worthless, which is where the greatest profit could be realized.
There are two main differences between taking a short position in a security and selling a call option. The first is that when shorting a stock, the short seller is responsible for paying the dividend of the shares they’ve shorted. When selling (or buying) an option, this is not the case.
The second difference is the amount of risk. No matter the share price, the profit made by the short seller is linear (as a function of zero), whereas the seller of the call option can earn a profit of 100% if the share price declines below the strike price as of a certain date. Of course, risk is a double-edged sword and losses are also amplified.
As always, it’s important to tread carefully and to consult a professional before taking action.