Last week I read an article whose subject was "short selling." I almost tossed my coffee in the process. What caused my gagging was that not once in the entire article did the author mention anything about hedging this most dangerous of trading strategies. Folks, if you don't hedge 'em over the long run, should you last so long, you will be taken under.
What must be coupled with any short sale is: Long Calls. That dopey article left out the hedging part for any short sale. Such ignorance is not bliss.
Never did any floor trader I knew sell any stock short without owning calls as their hedge. Never. And many times, the short sale was executed at the "wrong time." Yup, the stock blasted off almost immediately after we shorted the damn thing. Yet, we who owned those magnificent hedges, those long calls, made decent profits, some being the serious kind while being short the damn stock's shares in size.
That gain came from the hedges, the long calls (the long calls are a +two times basis the total shares sold short) doing handstands as those calls blasted off along with that shorted stock.
Options trading is sometimes a mind-blower, in a nice way. Serendipity can be in play with every trade.
The typical short sale trade setup was this: using a pre-set total of, say, 5,000 shares to be shorted, the calls bought would be at the money (atms), using the optimal (cheapest) volatility cost per diem (one month to a maximum of three months to expiry).
The delta -- that is, the measure of the extent to which the option is exposed to moves in the underlying asset -- for any atm call is +50. Ergo, basis the -5,000 shares to be shorted, I consistently bought 100 atm calls on that shorted stock.
Only 50 calls are used for hedging the short stock. The remaining long 50 call lot is the upside gamma, should the stock blast off! Gamma measures the rate of change for a stock option's delta. The +50 delta of the calls, multiplied by the +100 total of the long call position, created a +5,000 delta position in the calls.
That +5,000-long call delta, added to the -5,000 delta of the shares shorted, equaled a neutral delta position (i.e., zero net delta). Pros call that Delta Neutral. Now, add in the +50 calls owned, the un-hedged calls, and you get the plus gamma potential for those calls, should the stock rocket up in price.
My risk graph looked like this: V. The closer that the stock price over time was hanging around the bottom of that V, the more money was slipping out of my pocket and into someone else's (that's how time decay, or theta, was affecting the L of my P&L).
Being a zero-sum game, options trading always comes with "someone else" on the other side of the options trades. And most times those who sold the calls I bought were firm traders. They worked for a firm, not for themselves. Thus, their attitude was this: "hey, if I lose on this trade, I have plenty more trades open that the odds favor will pay for that other guy's gain. And if that guy loses (the calls decline), I win."
I was that other guy they were talking about, so I was like: "Ah, OK. I hope you win, dude, because if you win (the calls tank) that implies the stock I sold short (that 5,000 shares) just made a bundle."
Options, just like humans, are constantly expiring, ever-dynamic and their end-game is always in your focus every minute of any day. Chaos slows down their rate of decay. Chaos rises and increases in intensity as any stock declines. Ergo: literally and weirdly, chaos increases time. Very zen stuff here.
Consider this fitting and real example of the above: During my first year (1983 -- of what would become 10 years) in the trading pit I shorted 5,000 shares of Waste Management (WM) at $44 and immediately bought 100 WM calls, the $45 strike price, for 1.0 point. These trades were executed only a few days before WM's earnings release day. The risk graph was a beautiful V, a "Rembrandt" I called them (the V graphs). Expiry was in month+. Decay was thus ramped up. Decay does that as expiry approaches (decay is not linear, as in a straight line sorta way -- it's parabolic, which is so far over the head of the guy who wrote the above article).
A few days later was "earnings report" day. WM tanked in a one hour $39. Nice. I covered my 5,000 shares shorted at $39 as the sellers were quite willing and abundant at that price level. And I know that stocks go up big and down big and have a big odds tendency to stop moving in price at a number (as opposed to a fraction of a number/level).
Anyway, in come bids (firm guys covering!) for my long $45 strike calls. I don't "need" them anymore and I am a seller (along with my foxhole pit trader buddies). The floor broker announces his bid for 500 of those calls that we are long and want to close out too. The floor broker is closing for his customer -- that firm guy. Quickly (as in a NY second) we say in unison: "At 50c your 500!" He says "Take 'Em!" -- and the trades go up (finalized).
Net loss on our long calls was $0.50. That loss was two times basis the stock sold short. Thus, I lost $0.50 on 100 long calls, or -$5000. Big deal. I just made five points on the short stock times 5000 shares, or +$25,000 (shorted 5000 at $44 and covered 5000 at $39). Cha ching. Net gain was: $20,000.
That setup was, is and will be the: how to short stock while not getting your ass handed to you on a not-so-silver platter. And what you do not care about much is that the long calls bought as your hedge will probably, should you be so accurate with the timing of your short sale, expire worthless.
The financial media and maybe 99% of all those who trade today are clueless to the options trading strategy known as DNGP (Delta Neutral Gamma Positive) options trading. DNGP fits so nicely when shorting stock. That is especially the case when the overall volatility cost (the premium) for options is offered at historical low prices.
Using the DNGP strategy, a trader can be totally backwards and quite wrong with a short sale, and yet still make decent to excellent profits.
To sell short with no hedges in the position is not wise, and eschewing DNGP only shows the ignorance and lack of skills of the trader.
Today we read and hear about algo this and computer trading that. The best computer in the world is sitting on your shoulders. Turn it on!
This commentary originally appeared on Real Money Pro on Nov. 17. Click here to learn about this dynamic market information service for active traders and to get more articles like this from Skip Raschke, Doug Kass and others.