How to Short a High-Flying Stock Using Options

01/07/2011 5:04 am EST

Focus: STOCKS

Often when a stock runs higher very quickly, it then has price targets that seem to ratchet up by 5% or 10% daily as the analysts race to outrun the stock. The discussion soon turns to unsustainable P/E ratios, or the tech bubble of 2000, where valuations, earnings, or a real business were not important.  Everyone is then chomping at the bit to sell short this high flier. Inevitably, the stock continues to go higher, and as the shorts cover, it runs higher still, until the longs are very smug about their thesis and the shorts all wish they had some money left to try to short it again.

Get Creative

Sometimes being creative can open up opportunities to make “free” money off of these high fliers. Take Apple, Inc. (AAPL), for example. The chart is below:



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AAPL has had a phenomenal run, rising over 68% in 2010 from its trough in late January to the peak in late December, and over 32% in the last four months of the year. Today, analysts were raising their targets to $400 or more per share. This certainly fits the bill as a high flier. And many do want to short it. From this chart, there are three nearby support areas that show themselves at $320, $300, and $279. These could definitely be targets to close out a short. If you were to short it today at 334 and were able to ride it down to $320 or $300, you would make a pretty penny. Earning $1,400 or $3,400 is a nice gain. But you would also need about $10,000 in margin for each lot short, and there is that pesky problem that the stock could go up. After all, every analyst thinks it will, and they can’t all be wrong. If it rises, then you would lose money on the short. But there is another way.

Shorting Using Options Combinations

Using options, these support levels could also be used as strike prices on a combination put strategy to gain short exposure. Buying one July 320-strike put and selling one each of a July 300-strike and a July 280-strike put gives varying degrees of short exposure to AAPL until it falls below $260 a share. That would require a 22% downward move in the stock in six months, where all analysts currently believe that it will rise by 20%. Here is a screen print of the July options chain from yesterday’s close:



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The right side shows that this combination would yield a credit of $245 per combination executed based on the last trades of each option. The margin required for this trade is about $3,750, or a little more that one-third that of the straight short. So if AAPL does nothing, there is a 13% annualized return from just pocketing the credit.

The option payoff varies and starts to kick in when AAPL falls below $320. At that point, the combination at expiry is worth one dollar per share ($100 per combination) for every dollar AAPL falls below $320 to a maximum of $20 ($2,000 per combo) at a price of $300. If AAPL continues to fall below $300, the payoff remains at $20 until AAPL reaches $280 per share. Then, if AAPL continues to fall, the payoff begins to decrease by $1 for every dollar that AAPL falls until it reaches zero if AAPL were to close July 15 at $260. The payoff picture is below.



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There are some caveats that come with this trade. First, if you are not willing to own AAPL with a basis of $260, then you will have to sell the combo before expiry or dynamically hedge if it approaches that level. Second, this strategy will limit gains on the short exposure to a maximum of $20 per share and will not start to participate until the stock has already fallen $14 from its current price of $334 (at the time of writing).

Third, this combo does not need to be held to maturity. Often when the stock rises, the combo will also rise, creating an opportunity to sell it and pocket the additional credit. The point is that this strategy is not for someone who is looking to enter the trade and forget about it for six months. It needs to be watched, but perhaps it is worth it for the potential returns. Trade well!

By Greg Harmon of DragonflyCap.com

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