Selling Stock Short with Stock Options (Long Calls) - Options with Stock Strategy

People who establish a short stock position are bearish on the position. They anticipate the shares to decline. Using options to compliment this position can be used as either protection or income. You can either Short Puts or Buy Call Options. Each will provide a different hedge, but both of those option choices are bullish positions and can act as appropriate hedges - whether the goal is income or protection. This example will use a short sale of stock and the buying of a call option to protect it.

Example:

Short 100 shares BHN @ $75

This investor is hoping for a decline in BHN stock. When you sell stock short, you will eventually close the position like a normal stock purchase and sale later - but shorting stock is done in the reverse order. There is also unlimited risk when selling shares short because money is lost when the stock rises and there is never a ceiling on how high a security can rise.

Protecting this short sale with a Long Call Option Contract

If the risk in the main position is an increase in the market, to protect it, a hedge or stop loss must be used. In this case, the trader will use buy a call option.

The hedge will look like this:

Short 100 Shares BHN @ $75
Buy 1 BHN DEC 80 Call for $200

There are benefits and downsides to buying this call option. Unlike a normal “stop loss” order that can be triggered and executed without your direction, a call option can only be exercised when the buyer chooses. “Exercising” meaning the buyer has the right to buy 100 shares of the shares at $80. The downside is the option is more expensive. In this case, the cost for the contract is $200 - which is an immediate loss. There is also an expiration date on the contract. The short stock is covered (hedged) out to December.

Maximum Gain

The maximum gain for a short stock position is the stock declining to ZERO. If there was no additional option cost, the maximum gain would be $7500. But because the contract cost the trader $200, that must be shaved off the gain potential. The Maximum gain here is $7300.

Maximum Loss

The maximum loss would normally be unlimited if the short stock was left unprotected. The call option guarantees a buy back price of the stock at $80, so the maximum loss is the difference between the short sale at $75 and the buy back at $80 PLUS the premium spent on the option. The maximum loss formula works out to $700 in this case.

The breakeven

The Break-even is the point where is no gain or loss. The stock was shorted at $75 and the profit is a decline in the market, but the $200 premium needs to be deducted. The Break even is $73

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