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I have spoken a little bit with my discount broker and he said that selling short is safer than using options so I guess sine I am a new investor I may delay trading options until I have more experience. However, I am interested in selling short but havent read much about it so I am gonna read about it more and maybe use that strategy soon. What do you think about selling short? How risky is it? What are the odds in being successful? Are options more or less risky than selling short?

Sincerely,
SorrySam
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Hey Sam,

Did you read any of my options articles, as I suggested? If you had, you would realize that put options have limited risk whereas shorting stock has unlimited loss potential. Many brokers are ignorant on options and steer their clients away from them rather than admit that they don't understand options themselves.

http://www.fool.com/news/commentary/2006/commentary06011205.htm

The key to buying options is going out long-term. Don't buy or hold options with less than 42 days to expiration.

Jim
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...my discount broker and he said that selling short is safer than using options...
Are options more or less risky than selling short?



IMO, it's more accurate to say options are more volatile than stocks (short or long) but they aren't necessarily more risky. The risk depends upon how much you choose to invest. Perhaps an example is in order.

The other day I suggested knowing your an entry price, target price, and stop loss price before taking a position. Let's rewind the clock to Monday contrast bearish positions against the QQQQ's by shorting it and buy buy options (puts).

Short QQQQ
On Monday you could have gone short at $39.00 during the mid day. Say we anticipate the QQQQ's to take another leg down to $37 very soon so that's our target. Since the big May slide, it did hit a recent high of $40 so we decide to use $41 as our stop loss just in case the market breaks out and decides to rally instead.
- Entry of $39
- Target of $37
- Stop loss of $41

Options QQQQ - Jun 06 Puts w/ strike of $38
On Monday, those options could have been picked up for about $15 per contract (on 100 shrs). Options are a little more difficult to pick a target but we've in essence done so with the strike of $38, so we'll say our target is for the QQQQ to reach $37. That would give us roughly $100 per contract less the $15 premium, or $85 profit per contract. For simplicity sake, we'll hold the contract till expiry so our stop loss will be when the contracts expire worthless.
- Entry of $15
- Target of $37 ($1 below strike price)
- stop loss of $0 (or stated another way, we could lose our entire investment)


You have a $10,000 portfolio.
How do you compare these investment options?
How many shares or contracts do you buy?


Enter the Risk Management Plan. Let's say your plan dictates the following: Upon entry...
- no position will be greater than 20% of portfolio
- no position will risk more than 0.5% of portfolio

That immediately limits your position to a max of $2,000. That would allow you to short 51 shares of QQQQ or buy stocks you could buy 133 options on QQQQ.

Now lets look at the risk contraint. With a 0.5% risk on $10k we're talking about capping our losses at $50. In the case of shorting 51 shares of QQQQ, covering at 41 would result in a loss of $102. You can only invest $936 to short 24 shares and still stay within your risk limits. On the Options side, there is no way you can purchase 133 contracts because you risk losing your entire investment if the options expire worthless. At $15 a contract you can invest $45 to purchase 3 contracts and still keep your max lose at or below $50. Note the difference in the amount invested.

Now compare the potential gains. We're looking at the upside of shorting 24 shares of QQQQ and buying 3 contracts of puts w/ strike of $38. If the QQQQ's drop to $37, you've invested $936 and are sitting on a $2/shr profit or $48 (a 5.1% return). With the puts, they will have expired in the money which gives you the right to sell shares of QQQQ for $38 which is a $1/shr profit on 300 shares which is 300 less the $45 cost of the option. That $45 investment results in a $255 profit or 566% return.

If your eyes are twinkling at the huge profits, you've missed the point and your focusing on the wrong thing. The key is to control your risk or potential loss. That's what allows you to sleep at night. Options aren't necessarily more risky if you control your risk. If you don't then your broker is absolutely right.

Regards
RB

PS - Russ from Real Time Trader deserves props for much of this. He's a regular on some of the TMF boards.
http://www.therealtimetrader.com/realtimetrader/understandingriskreward.htm
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Come to think of it, that person who gave me that advice wasn't objective...he works at a discount broker that doesn't offer options. I will keep my options open to options. I will need to read more about it and what is the best low risk way of using them. I guess I go to go through the hassle of opening another broker account for options because scottrade doesnt offer them (dont know why). I registered for an account at optonsxpress.com but didnt fund it yet. I have to see what limited resources I should use to fund that account....maybe I should sell some of my losers and use hte proceeds to fund that account?

thanks for your advice...shorting stock does seem risky unless you know exactly what stock and when it will decline. I was wondering what stocks do you routinely use for your options?

Sincerely,
Sorrysam
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After reading TMFhamp and your messages today, I am rethinking what the scottrade worker told me. I printed out your message so that I can read it more closely since it gives a comparison of the pros and cons of both selling short and options. I honestly like the idea of an affordable insurance policy that would not expire in a matter of months. We have insurance for our cars, houses, health, etc but why not our investments? Is it because options are not well known (if they can be safe) or are they too expensive to be cost efficient or are they waste of capital since I have read that something like 80% of options expire without being used? Both of you have made me rethink my stance toward the use of options. I will leave a message tomorrow after I have thoroughly read and thought about your message (I just skimmed through it becasue my eyes kinda hurt) and may update you guys if I do decide to open an options account. Thanks for both of your help.

Sincerely,
SorrySam
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Don't take my comments as endorsing options over stocks. Just want to give some context to the term risk.

You appear to be on the right track, Sam. Keep trying to learn as much as you can. Try to develop a style that fits you and watch those that have a successfull track record. I strongly recommend starting with paper trading before you begin putting your hard earned money into play. It might not seem as exciting but it's better than making beginner mistakes with your own money. You will make mistakes.

Good luck
Rick
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<<I was wondering what stocks do you routinely use for your options>>

Hi Sam,

The key to options is limiting your universe to liquid names. If the stock is liquid, the options usually will be as well. I trade mostly index options and ETFs that trade millions of shares per day like SPY, QQQQ, IWM.

Jim


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<<I have read that something like 80% of options expire without being used?>>

Hi Sam,

The 80% figure is is a myth. Actually, only 30-35% expire worthless.


http://www.cboe.com/LearnCenter/OCShowDocument.aspx?DIR=LCOptionsCorner&FILE=20010611.doc&CreateDate=11.06.2001


Best,

Jim
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Sam:

In his outstanding book "You Can Be a Stockmarket Genius" Joel Greenblatt recommends buying LEAPs (long term options of up to three years). His strategy is to find solid companies that are temporarily beaten down for whatever reason, by LEAPs, then wait for the stock to go back up. By doing this, even a relatively small gain in the stock can result in a much larger percentage increase in the option price.

For example, back in February I bought Jan. 2007 calls on JNJ for $3.40 per share, or $340 per contract, with a strike price of $60. JNJ is now selling at appx. $61.50, and the options are now going for around $4.60, or a gain of 35% even though the stock has only gone up about 2.5%.

As another poster mentioned, the key is buying relatively long-term options. Since January, JNJ has bounced around from $62 to $57 and back. Because I bought Jan 07 LEAPs, I could ride out the volatility with no risk of my options expiring worthless.

Greenblatt's strategy is a relatively low risk one. You buy options on solid companies and then wait paitently for the stock to go back up. It's classic value investing, but with a twist.

Paul
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You sell short, your risk is virtually unlimited. You buy a put, all you're risking is the cost of the put plus comissions.
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<The 80% figure is a myth. Actually, only 30-35% expire worthless>

The 35% that expire worthless isn't necessarily bad. I can think of two instances where you might want the option to expire worthless.

(1) If you put write for income, you pocket the money for the put, and wait hoping that it expires worthless, so that you can keep the money.

(2) You buy a stock with an earnings report coming out soon. You expet the stock to soar on a good report, but realize that there could be a bad report, causing the stock to tank. You buy an option as insurance, and hope that the stock soars, and that the option will expire worthless.

There are probably many other reasons, but that is two of them off the top of my head.

Huge
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Hi Huge,

Your first example doesn't count because it involves the sale of an option. Obviously, sellers of options want them to expire worthless so that they can collect the entire premium. The buyer of the option isn't so fortunate.

Your second example is a good one.

Jim


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what options do you trade with spy, qqq, iwm?
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Interesting....I am still a little behind on the lingo...like what is the difference between not exercising it and itexpiring? Won't both usually end up a loss?
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what options do you trade with spy, qqq, iwm?

These ETFs don't have (many) options on them since you can just buy the options on the underlying indexes.
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I find the leap concept interesting and I guess more comforting than short term options where the the clock ticking would make me nervous. I just opened my options account but will probably paper trade for a while or/and consider just shorting a few stocks not spending alot of money (just a little...but still will be picky on what stock I eventually decide to choose).
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what is the difference between not exercising it and itexpiring? Won't both usually end up a loss?

All options positions (that are not closed out early) are either exercised for a payout (if they're in-the-money), or expire worthless.

The seller of the option hopes that (either he can close out the position early at a profit or) the option expires worthless.

The buyer of the option hopes that (either he can close out the position early at a profit or) the option ends up in-the-money and he exercises it.
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Can't you put a buy limit order to protect yourself when shorting a stock just like a sell limit order to protect yourself from losses on stock long? Is this statement accurate or is just from another author trying to sell a book?
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For the second option....would it usually be better just to put a stop sell order on that stock? It seems like there are people (not in this forum) who criticize the use of options as risky (which I know depends on what type of options are being used) but also as a waste of money becuase of the criticism that its a wate of money because they usually expire worthless (which now some of you are saying its not true). Too bad I could not watch you guys trade....its seems the best teacher (besides experience because I dont want to be broke and then figure out how I can avoided becoming broke) is learning from others whom are successful. I would love it people on fool.com would have some kind of investing convention sometime during the year where we can all meet and learn from one another. Hopefully they will do something like that in the near future.
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<<These ETFs don't have (many) options on them since you can just buy the options on the underlying indexes.>>

This statement is simply wrong. I trade options on the SPY, QQQQ, and IWM frequently and they are very liquid and easy to trade. The SPX, NDX, and RUT index options are less liquid than the ETF options.

Jim

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Does the option buyer automatically get this profit if the option expires while its in the money? Or does he or she have to exercise it anytime BEFORE it expires?
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I wish there was a fool.com chatroom where we can talk back and forth instead of sending a million messages....much more efficient. Sorry if I annoy you guys with all my replies...first time I was able to get on in a little while and after tomorrow...I probably wont be able to get on for a few weeks.
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<<Does the option buyer automatically get this profit if the option expires while its in the money? Or does he or she have to exercise it anytime BEFORE it expires?>>

Hey Sam,

Equity options that are at least 25 cents in the money are automatically excercised. Index options that are one cent or more in the money are excercised.

http://www.888options.com/help/faq/exercise.jsp#7


Jim
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I trade options on the SPY, QQQQ, and IWM frequently and they are very liquid and easy to trade.

How do you find them then? Several times in the past I've looked for the option chains of these ETFs and found nothing.
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Sam,

Where are you getting your information?

You really need to read a good source of information, like a book or an options education website, rather than trying to have all your questions answered piecemeal in a forum.

A limit order does not protect you from anything except buying or selling at a price you didn't expect. I assume you're thinking about a stop order.

Not all books are evil you know. (and you can often check them out for free at a local library)
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Does the option buyer automatically get this profit if the option expires while its in the money?

I think this varies depending on the broker and on the exchange.

Sometimes it's simpler to just SELL the option prior to expiration rather than going through with the exercise.
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Equity options that are at least 25 cents in the money are automatically excercised.

You sure about that Jim? the page you referenced says:

The Options Clearing Corporation ("OCC") uses the 25 cent threshold for customer orders, but your firm may have a different threshold.
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Can't you put a buy limit order to protect yourself when shorting a stock just like a sell limit order to protect yourself from losses on stock long?

Certainly. However, I believe it is called a "Buy Stop".

Is this statement accurate or is just from another author trying to sell a book?

NO, and I have no idea why you'd believe that.
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<<How do you find them then? Several times in the past I've looked for the option chains of these ETFs and found nothing.>>


http://finance.yahoo.com/q/op?s=spy

http://finance.yahoo.com/q/op?s=qqqq

http://finance.yahoo.com/q/op?s=iwm


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