Bearish investors have two common strategies at their disposal: short selling and put options.
Short selling is the most aggressive bearish strategy characterized by the highest degree of risk. Used by hedge funds, institutions and retail investors, it has developed into a popular strategy for profiting from market declines. Another strategy for bearish investors entails the use of options.
There is, however, a third and lesser-known bearish strategy that combines stocks and options. Known as a "Hedged Short Sale" or "Synthetic Put," this strategy simply involves the shorting of a stock and the simultaneous buying of "Protective" call options. In this strategy, you artificially create a security with put-like characteristics and limited risk.
As discussed in the previous article, short selling implies that the investor borrows a specific stock that he or she does not own and sells it in the market at the prevailing price.
Profits arise when the shorted stock declines to a level that covers the transaction fees paid to initiate the strategy. Once at the preferred level, the short seller would buy back the stock and return it to the registered holder.
But as you may recall, the maximum risk of a short selling strategy is unlimited in theory since the stock price has no upper bounds. In reality, however, losses are generally limited by the short seller's inability to maintain the adequate margin required as the stock rises in price.
In a put option strategy, the maximum risk is limited to the premium paid for establishing the position.
The most significant difference between short selling and put options is the time element involved for the strategy to pan out. Bearish investors often favor short selling because there are no time limits, other than a possible situation when the registered holder calls in the borrowed stock. Short selling has time on its side whereas put options have a limited life.
Given this, for investors favoring short selling, risk can be minimized by initiating a Synthetic Put. This short-term strategy allows the bearish investor to profit when the stock declines to the downside, but at the same time, protects the short position in case the position goes against the short seller.
A Synthetic Put is also desired when a specific put option may not be available.
The use of a call option in a short selling strategy helps to minimize the risk of substantial losses that can arise.
In addition, be aware that should the call option expire prior to the stock moving down to where you want it, you could simply buy another call option to maintain the hedge.
Warning: Due to the higher risk inherent in options, I recommend you speak with an investment professional before deciding to employ any strategy involving options.
See you soon!
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George Leong is the founder of www.investornomics.com - a provider of independent stock and option trading commentary. He has a degree in finance/economics and offers over 15 years of research experience in investing and trading.
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