# Selling stock short and then buying OTM call option



## janus10 (Nov 7, 2013)

I had never heard of this strategy until I just read it right now.

There is a stock with a large short position on it. Some analysis suggests it is trading well below book value and may be a good candidate for a takeover and replace incompetent management. 

So, what are the pitfalls with selling a stock short and buying OTM calls six months out? The big risk I see is if the stock rises to a level where the options barely expire worthless. That's a double whammy. 

Does anyone have a spreadsheet which already calculates the risk / reward or is this one that can be easily calculated by two different scenarios?


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## humble_pie (Jun 7, 2009)

i've never done this but i believe it's a common strategy. It's the numero uno reason why high call volume + elevated call open interest do *not* necessarily indicate bullish interest in a stock, which is what many investors assume.

instead, active volumes + open interest can indicate the presence of short artists, exactly as you are describing.

still, i'm puzzled. If the stock is an unrecognized jewel - undervalued, good takeover candidate, etc - then why would one short? why not just go for a bullish option spread?

the envisaged pitfall is due to the OTM nature of the call. I imagine the cure is to buy calls with a strike very close to the short price. These, of course, are much more expensive. Also i'm never fond of scenarios that script things like Takeover Must Occur Within 6 Months


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## Rusty O'Toole (Feb 1, 2012)

Statistically speaking stocks with the largest short position tend to go up more than average over the next 2 or 3 months.

But if you want to do this, suggest you simply buy a put. It's cheaper and has the same risk/reward profile as shorting the stock and buying a call.

Incidentally this strategy of selling short and buying a call, is known as a "married call".

If you insist on doing the married call, the cheapest way to do it is to sell short and buy an in the money call. One with about a 70 delta. This gives you full protection at minimal cost. I know the call is expensive but a lot of that is intrinsic value, which you will get back. The only out of pocket expense is the extrinsic or time value. Plus there are fees to borrow the stock to sell short (making the put option look better and better).

Look at it this way. Suppose you sell the stock short at $50. And buy a $48 in the money call 6 months out for $3. Your total expenditure is $50 + $3 = $53.

But you have the right to cover your short at $48 giving you a $2 profit. So you only stand to lose, at the most, $1.

In this case the stock would have to drop below $47 for you to make a profit.

There are other angles to it, for example the call will have some premium value all the way to expiration. And you can adjust the trade and sell options against it for extra income. But, you have the basic idea.


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## Rusty O'Toole (Feb 1, 2012)

"There is a stock with a large short position on it. Some analysis suggests it is trading well below book value and may be a good candidate for a takeover and replace incompetent management. "

Sounds more like a buy than a sell. Could be a good candidate to buy, then protect yourself by buying a put. In other words a "married put" - the opposite of the married call.

Buy the stock and protect yourself by buying an in the money put. Give it a few months to sort itself out, if it doesn't take off close out the trade with a small loss.

When a stock is beaten down like this, a little good news can send it up 50% in a few days. Warren Buffett started out investing in stocks like this, he calls them "cigar butt stocks". Because you can pick up a cigar butt off the sidewalk and it might have 1 or 2 puffs left in it. His advice, if you get a bounce and can make a 50% profit, count your blessings and get out.


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## humble_pie (Jun 7, 2009)

Rusty O'Toole said:


> Suppose you sell the stock short at $50. And buy a $48 in the money call 6 months out for $3. Your total expenditure is $50 + $3 = $53



moi je crois que non. If stock can be shorted at 50, a 48 call 6 months out is going to cost significantly more than $3. Its intrinsic value is already $2 & the volatility suggested by the underlying in the example would price TV in the $2 range, for a total offer price guesstimated around $4.50, imho.

as for total expenditure, idk, how could it be $50 plus cost of option? the short artist here receives $50 from the short sale, he doesn't pay it. His cost will be the option cost, imho.


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## lonewolf (Jun 12, 2012)

Janus I don't like the strategy your thinking about. My rule of thumb is buy in the money or deep in the money calls & buy out of the money or far out of the money puts when the time is right.


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## atrp2biz (Sep 22, 2010)

Back to the OP, why don't you just buy the put?

Long put = Short stock + long call

I also agree with others. A large short interest can be viewed as bullish--a slight upward movement in the stock will cause a squeeze which further accelerates the rise.


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## avrex (Nov 14, 2010)

Rusty O'Toole said:


> Statistically speaking stocks with the largest short position tend to go up more than average over the next 2 or 3 months.


 Actually, I've heard that it's the opposite that is true, based on this article.

The author states, based on the graph below, "it is fairly clear that short sellers, on the whole, have been correct in their pessimism."










As others have stated, *buying a put* would be the easiest way to play this.


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## humble_pie (Jun 7, 2009)

nae nae laddies

the bluidy stoch is gang to rise. Undervalued. Takeover.

tis a knave would buy a puht


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## Rusty O'Toole (Feb 1, 2012)

I don't happen to have a stock at my fingertips that sells for exactly $50 so will use Oracle @ $41.59.

Right now the Dec 15 38 call is $4.60 (mid price) and has a delta of .73. It has $3.59 of intrinsic value and $1.01 extrinsic or time value. 

Someone who sold Oracle short at $41.59 and bought the call would have a position as follows:

$41.59 from selling the stock, minus $4.60 for the call, means they would be $36.99 to the good.

But, they would have the right to buy the stock back for $38. $38 - $36.99 = $1.01.

So, they would have $1.01 at risk. No matter what happened, even if the stock went to $100 a share, that is all they could lose.

Hope this is clear.

At the same time they would have to buy the stock back for less than $36.99 to show a profit. I don't know if that is where it is going but the Dec 15 call gives you 182 days to find out.

Or, you could buy the Dec 15 38 put for $1.17 (mid price), have $1.17 at risk and profit if the price falls below $36.83.

My example may have been a little rough but not out by too many orders of magnitude. I believe it conveyed the idea.

By the way the above figures came from Think or Swim's Trade page, as of 4:30 Friday June 19 2015.


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## el oro (Jun 16, 2009)

Rusty O'Toole said:


> But if you want to do this, suggest you simply buy a put. It's cheaper and has the same risk/reward profile as shorting the stock and buying a call.


Long put = short stock + long call in theory but your Oracle example illustrates that it falls short in reality. You have 16% more capital at risk for the same trade when you go the put route. If taxes were equivalent, short stock + long call wins.

The OP didn't frame the situation where either strategy would make sense though. It's more appropriate where you believe the incompetent management will stay in place driving the stock price down but want to protect against the possibility of a takeover.


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## KaeJS (Sep 28, 2010)

All I can say is...

Make sure you're right. LOL.

Shorting a stock and then buying an OTM Call is asking for a bit of trouble. You an only win one way. If the stock stays flat or goes up, you are screwed. What a waste...


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## humble_pie (Jun 7, 2009)

wrong

if stock falls, a true short artist with long call wins, once stock falls below cost of call

if stock flatlines, short artist risks to lose cost of call only

if stock rises, short artist is covered & will always break even


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## KaeJS (Sep 28, 2010)

How can the short artist break even when the price goes up?

If you short a board lot at 40 and buy an OTM Call for $42 and the price is now $43... how did you break even?

You've lost $300 for the short and the cost of the call.
The only profit is $100 on the Call.


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## humble_pie (Jun 7, 2009)

why would u think he hedges with only one call?

plus that $1 calculation on the call is wrong as well ...


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## KaeJS (Sep 28, 2010)

humble_pie said:


> plus that $1 calculation on the call is wrong as well ...


Explain.


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## humble_pie (Jun 7, 2009)

it goes something like Explain _Please_

never a good idea to order people around, especially when one is making mistakes each:


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## KaeJS (Sep 28, 2010)

I haven't made any errors.

Using the same example for simplicity...

If you are shorting at $40 and buying a call for $42, you will lose money on the trade if the stock does not go down. All you are doing is limiting the amount you can lose, but you will still lose.

Even if you were to buy an ATM Call, you would still lose. You would be subject to the loss of your premium and the short and the call profits would cancel each other out.


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## humble_pie (Jun 7, 2009)

KaeJS said:


> If you are shorting at $40 and buying a call for $42, you will lose money on the trade if the stock does not go down. All you are doing is limiting the amount you can lose, but you will still lose.
> 
> Even if you were to buy an ATM Call, you would still lose. You would be subject to the loss of your premium and the short and the call profits would cancel each other out.



quite wrong, the calls will rise with the stock. The calls were purchased to act as a hedge. Like i said, if the shorted stock goes in the wrong direction & rises instead, then the call-hedged short artist will break even. He will not lose. His hedge will work.


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## KaeJS (Sep 28, 2010)

Yes. The calls will rise with the stock.

The only way that you might be able to break even is to buy an ATM Call and then Sell to Close that call collecting a higher premium followed by purchasing the shares in the market to cover the short.

If you could break even every time, then why wouldn't people always short stock long call? Are you implying there is no risk in this type of strategy?

If the stock does not go down, you will (depending on premiums and whether or not you are closing out the option position) lose money.

Edit: The only unknown and undetermined factor is the extrinsic value of the call after the stock rises. This is important because this value will change depending on time and future outlook or sentiment for positive future price movements in the underlying stock.


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## KaeJS (Sep 28, 2010)

In any event, there is risk in shorting and buying OTM calls.

OTM Calls leave a gap between the short price and the hedge price. This gap, along with the cost of the call could lead to a loss.

If the short artist pays $0.50 for the OTM Call, the stock would have to hit $44.50 to break even. And that's an 11% increase in stock price from the short price. Hardly risk free.

The only more secure way to do this is to write ATM calls, but you are still not guaranteed to break even depending on the premium paid and the stock price at the end of the trade.


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## KaeJS (Sep 28, 2010)

KaeJS said:


> You've lost $300 for the short and the cost of the call.
> The only profit is $100 on the Call.


I did make an error here. The loss is $200. Not $300.
But this is still a loss, as you've lost $200 on your short plus the premium paid for the call. The call itself only ended up providing a $100 gain.


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## humble_pie (Jun 7, 2009)

KaeJS said:


> Yes. The calls will rise with the stock. But the loss from shorting will also rise with the stock.
> 
> The only way that you might be able to break even is to buy an ATM Call and then Sell to Close that call collecting a higher premium followed by purchasing the shares in the market to cover the short


it's not a question of *might.* The short artist in this hedged scenario *will* break even.

why don't people do this every time? thinggabbouddit, no one sets out in investing to just break even.




> If the stock does not go down, you will (depending on premiums and whether or not you are closing out the option position) lose money.


this is wrong. We've gone over this 3 times. It was transparent from post numero uno upthread that the original position was fully hedged. Please do not pretend that a party smart enough to put a hedge in place, will somehow be unable to use it.

from time to time, this forum sees a certain amount of novice option babblespeak from members who seem to be showing off rather than pursuing the growth of new knowledge. This is regrettable, because options can be dangerous little creatures. Let's hope that newcomers are not influenced by the boasters.

some in cmf, like GOB & dmoney, have shown that they can handle options very well. It appears that the OP in this thread was headed in that direction each:


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## KaeJS (Sep 28, 2010)

The thread is about selling a stock short and hedging through buying out of the money calls.

Short stock price: $40
Call Strike: $42
Premium: $0.50

The short artist needs the stock to go up to $44.50 before break even. I don't understand what is incorrect with what I have said.

As stated, even using ATM calls, it could result in a loss. There is no guaranteed break even that you speak of.

Short stock price: $40
Call strike: $40
Call premium: $0.75

What happens if the stock is $40.25 at the end of the trade? You have a loss.

"Please" tell me we can agree on this.


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## humble_pie (Jun 7, 2009)

in his very first message the OP foresaw that a slightly rising share price - ie shares hover but never rise above cost of calls - would cause him to lose this cost-of-calls. This expense is so insignificant it can hardly be called a loss. More like the price of being in the stock market in the first place.



janus10 said:


> So, what are the pitfalls with selling a stock short and buying OTM calls six months out? The big risk I see is if the stock rises to a level where the options barely expire worthless



in the 2nd message in the thread, i suggested that ATM calls would reduce this risk.



humble_pie said:


> the envisaged pitfall is due to the OTM nature of the call. I imagine the cure is to buy calls with a strike very close to the short price. These, of course, are much more expensive. Also i'm never fond of scenarios that script things like Takeover Must Occur Within 6 Months



i'm out of this leg in the conversation now, as it seems clear that you wish only to pick fights ...


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## Rusty O'Toole (Feb 1, 2012)

el oro said:


> Long put = short stock + long call in theory but your Oracle example illustrates that it falls short in reality. You have 16% more capital at risk for the same trade when you go the put route. If taxes were equivalent, short stock + long call wins.
> 
> The OP didn't frame the situation where either strategy would make sense though. It's more appropriate where you believe the incompetent management will stay in place driving the stock price down but want to protect against the possibility of a takeover.


Don't forget that you have to put up margin to sell short, and pay fees for the privilege. They are still similar trades with similar risk/reward profiles but nowhere do I say that they are exactly identical to the penny.


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## Rusty O'Toole (Feb 1, 2012)

There is a phenomenon that has not been mentioned yet, based on the fact that 'at the money' options have the highest time value or extrinsic value.

Considering the position of sell short stock/buy an ITM call, if the stock dropped the short stock would gain cent per cent what the put lost in intrinsic value, but the extrinsic value of the call would rise with the maximum extrinsic value being the ATM call. So the punter might check the value of his position, and be surprised that he made money when he thought he was breaking even.

This would have to happen quickly so that the time value did not melt away.


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## Rusty O'Toole (Feb 1, 2012)

Yeah it would kill him to admit anyone else is right or he is wrong lol.

The straight up hedge protects the position and limits the loss to the extrinsic premium paid. I dare say we would all be better off, if the biggest loss we ever took on a position was 5%.

But there are ways to sell options against an existing position, roll options or buy extra options to enhance profits or eliminate the possibility of loss.

If you want to close a position after 1, 2 or 3 months , because the stock has not moved, the 6 month out options will still have some time value. So if the stock does not move much either way, you will break even or perhaps have a tiny profit or tiny loss of less than $1 a share.

And if the stock moves big one way or the other you will have a limited loss or an unlimited profit depending which way it goes.


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## humble_pie (Jun 7, 2009)

Rusty O'Toole said:


> Considering the position of sell short stock/buy an ITM put, if the stock dropped the short stock would gain cent per cent what the put lost in intrinsic value ...



good grief, we izz shorting stk & buying puts now? whatever happened to short stk plus buying calls?

never mind. Short stock plus buy puts has to be the mother of all super-bears. The only thing that could make it worse, ie turn it into stalin's daughter in siberia, would be short-stock-plus-buy-puts-plus-sell-naked-calls.

perhaps this might be something for lone wolf to consider, as he waits for doomageddon to materialize .each:


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## humble_pie (Jun 7, 2009)

Rusty O'Toole said:


> There is a phenomenon that has not been mentioned yet ... This would have to happen quickly so that the time value did not melt away.



re the mystical dance of the ever-shifting option numbers, it occurred to me while watching canada's gold champion olympic hockey game at Sochi last winter, that hockey is very much like option trading, except that hockey is vastly more difficult.

the hockey players have to know at all times, not only where the puck is going to be one or 2 or 3 seconds into the future, but they also have to know where each one of their teammates will be skating during that same future second or 2 or 3. Not where each player is skating now, but where speed, location & speed of the moving puck, position & speed of all the other players say the game will look like 3 seconds on.

these team functions don't affect options traders, who also have computers, while each hockey player skates untethered on the ice with nothing but his bare eyes. They are what make hockey so much more challenging, imho.


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## londoncalling (Sep 17, 2011)

I am shorting Greece and selling puts on BRIC banking. 
I am selling long calls on Putin and covering my short position by buying an ITM call on austerity...:stupid::hopelessness:

I keep reading the options thread and just when I think I got it figured a thread like this confuses me. Obviously, like any investment theory, there are no sure fire methods. In the meantime I will keep reading my options books and playing with my virtual account. I realize more and more the options game is a full time job. One I currently do not have time for. In the meantime please continue the debate as \I do pick up slivers of knowledge and my curiosity keeps me following.

Cheers


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## Rusty O'Toole (Feb 1, 2012)

humble_pie said:


> good grief, we izz shorting stk & buying puts now? whatever happened to short stk plus buying calls?
> 
> never mind. Short stock plus buy puts has to be the mother of all super-bears. The only thing that could make it worse, ie turn it into stalin's daughter in siberia, would be short-stock-plus-buy-puts-plus-sell-naked-calls.
> 
> perhaps this might be something for lone wolf to consider, as he waits for doomageddon to materialize .each:


Thanks for the correction, I got the put and call mixed up because I am more used to thinking in terms of married puts and long stock. The idea of selling short and buying a call doesn't make much sense to me but that is what the OP was asking about.

I went back and fixed my mistake.


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## humble_pie (Jun 7, 2009)

Rusty O'Toole said:


> The idea of selling short and buying a call doesn't make much sense to me but that is what the OP was asking about




rusty this strategy, ie short stk + long call, will make sense to you if you think it through. You're good at thinking option strategies out to their final unwinding, so i know you're going to "get it."

investor shorts a stock. If stock goes down, good on him, he gains.

but suppose stock goes up? oops, he loses. But that's why he has bought his calls, that's why he holds the long calls as a hedge. If perchance his original forecast was wrong & stock goes up instead of down, then his calls will rise more or less in tandem with the stock. He won't make any $$ but at least he won't lose.

as atrpdocbiz shows us upthread, buying a put would have a similar result. Although personally i believe there is a small cost saving to the short-stk-long-call combo, instead of buying a put.

if Oops happens & share price rises, the buyer/holder of the long put will lose the cost of buying the put. On the other hand, if Oops happens the short-stk-long-call artist will more or less break even.

another small cost saving will stem from the fact that, in today's world of cuckoo zero interest rates, puts are generally priced higher than calls. IE it costs more to buy a put than to buy its paired call at the same strike.


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## Rusty O'Toole (Feb 1, 2012)

Of course I "get it". When I say it doesn't make sense, I mean I don't know why anyone would want to do it when it would be cheaper and easier to do a put spread or some other option strategy.

I can see buying stock as a long term investment and buying the put to protect your investment short term in case you are wrong. Even though technically a long call would give similar results. 

But going short and buying a call doesn't make sense. Or at least, is doing things the hard way.


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## el oro (Jun 16, 2009)

You've already illustrated that the short stock + long call is cheaper than the put. Unless you're trading maybe 1-2 calls at a time, a massive 16% spread isn't going to be overcome by small margin costs and commissions.

Current put-call disparity (in general) favours strategies where you buy calls or sell puts instead of the reverse.


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## humble_pie (Jun 7, 2009)

el oro said:


> Current put-call disparity (in general) favours strategies where you buy calls or sell puts instead of the reverse.



true

alas this has done a number on the collaring biz

maybe that's a good thing? everybody wearing tees anyhow


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