Is Shorting a Stock the Best Way to Go When You are Bearish?

The other day I received a telephone call from a friend to tell me he was quite certain that a company was going to miss its mark on the next earnings announcement which is supposed to come at the end of January.  He told me he wanted to short the stock (which we will call ABC) and wanted to know what would be required for him to do so.  This call was not made to get my opinion on ABC.  His mind was already made up as he was very certain in his opinion that ABC was going to drop.

I explained the MARGIN REQUIREMENT and told him that there was an interest charge for borrowing the stock to SELL SHORT.  I then asked him where he saw ABC dropping to when the EARNINGS disappointment kicked in.  With ABC currently trading at around 17, he told me it could drop 2 points to 15 but he also thought there was a possibility of it getting hit harder and taken down to as much as 11. Based on his strong opinion that the EARNINGS disappointment will send ABC to lower prices, I told him that shorting ABC would certainly bring him some nice profits if he were correct and ABC dropped.  As the OPTION STRATEGIST that I am, I also told him that there could be better opportunities out there by using STOCK OPTIONs.  We can use them to profit from his BEARISH opinion on ABC while lowering his risk along with his lowering his cost.

Let?s break this situation down and see what might be the best way to go.  Keep in mind that he is looking to put on a STRATEGY that will profit when ABC declines.  His mind is already made up and he is committed to and looking to use a BEARISH strategy for ABC. As OPTION STRATEGISTs, we are simply looking for a strategy that might be somewhat more appealing than shorting the stock.

With ABC trading at 17, and the Earnings Announcement coming after the January Expiration, we will use the February Option prices.  At this time ABC?s options are thinly traded and only 3 strikes (15 ? 17.50 ? 20) are listed, so any DEEP IN THE MONEY CALL Strategies are not available.  Here are the prices:

For comparison sake, we will use 1000 Shares of ABC or 10 Contracts which is equal to 1000 shares of stock.  Keep in mind I am NOT factoring in commissions or interest charged for borrowing the stock to sell short.

Based on his wanting to Short ABC, it?s very easy to recommend that he buy 10 of the February 20 Puts.  The $200 paid in premium is definitely worth the expense as it lowers the total cost severely, not to mention the risk as we can see in the final illustration below.

As we can see, there are some huge advantages to using OPTION?s for this particular bearish opinion.  As OPTION STRATEGIST?s, we provided him with a position that will still profit from an ABC decline, but more importantly, if he happened to be wrong in his forecast and ABC rallys, we cut his exposure and lowered his risk.  I did not advise purchasing the February 15 Puts because it is possible for ABC to only slide 2-points and the 15?s will be a loser, and the 17.50 Puts were not a candidate for obvious reasons.

The point here is that we have plenty of choices on how to implement an opinion.  If we know what is available and how to apply these OPTIONs, we can surely make a huge difference by gaining a better advantage.