When it comes to shorting, most investors don’t even go there. It’s risky, difficult, and most investors don’t even know how to get started. There are plenty of difficult ways to do it (at least, for retail investors), so what’s the easiest way to short a stock?
Let’s back up for a moment, and look at the traditional way to short. Say you think Amazon.com is overvalued. As I write this, shares are a hair over $307. Because I assume you’re all high rollers (WHOO IMPORTED BEER), you’re about to short 100 shares of the most overvalued internet retailer in all the land, which will set you back a cool $30,700.
So you approach your broker, and say you want to short 100 shares. You’ll borrow 100 shares from another investor, and sell them into the market. Your broker takes that $30,000 and puts it aside (and by put it aside, I mean lends it to other people), in case it needs to buy those shares back in a hurry. Remember, somebody out there is missing their 100 Amazon shares, and are none the wiser.
In order to short, you have to meet a few conditions. You have to be approved for a margin account, because you’re borrowing those shares. You also have to enough in assets that you can maintain this position. Remember, Amazon could go up forever, meaning at some point you’d be forced to sell the position and cough up the rest of the money owing. That’s called a margin call.
Also, you have to pay interest when you borrow those shares, usually around 7% or so. Additionally, you’d be responsible for paying any dividends owed to the original shareholder, since his shares are gone.
If you’re shorting the banks (like I did, sort of) you’d be looking at 10-11% a year, just as a carrying cost. If you’re short for 3 years, the stock has to fall a third just for you to break even. Big investors can get a better deal than you or I can, but they’re still on the hook for the dividends.
(Aside: I used options to short 4 of Canada’s largest banks back in July of last year. I’m since out of that position, losing about 20% on it. I’ll explain how that went down sometime soon.)
Back to Amazon. You want to short it, but aren’t interested in putting $30k at risk. How would you go about it?
By far, the easiest way to short a stock is by using options.
Here’s the option chain for the stock. Let’s look long-term, since shorting is something that often takes a while to play out.
Let’s focus our attention on the Jan 15, 2016 puts. For $30.60, you can buy the right to sell one Amazon share on the date. For 100 shares, you’re looking at a little more than $3,000, because math is hard for some of us.
Here’s why this is the easiest way to short a stock. You go on your online broker (use Questrade, they’re the bestest!), put in an order for something like this, and boom. You’re officially shorting a stock.
Of course, shorting isn’t without risk. For this example, Amazon has to fall to a little below $250 before you’ll make any money on the stock. If you were to choose the $330 option, the price would only have to decline to a little below $278 in order to make money, but you’ll invest nearly double the original principle in the first place.
The other thing is the artificial time requirement we’ve put on this specific trade. Amazon has approximately a year and a half to fall. If it doesn’t, and your option expires worthless, you’re out the entire investment. If you’re looking to short this way, keep two things in mind:
- The potential gains are huge, but so are the potential losses. If Amazon fell to $220, you’d double the money on the original option. A regular shorting investor would make about a third of his money.
- It’s probably best to do a few of these, or make it a very small part of your portfolio. I cannot stress that part of it enough. It’s a risky trade, even when the premiums are much less.
There are less risky ways to do this, but they won’t pay as much. Say you wanted a short-term short on Amazon, so you paid $10 per share for the right to sell at $305 a couple months from now. All that has to happen is for the stock to fall to $295 to make money. Amazon is volatile, so it could easily do it. And even if it doesn’t, the price action on the option in the meantime could rise, and you could sell it to someone else in the meantime. In the world of options, taking a profit is wise.
So just because I outlined the easiest way to short a stock, doesn’t mean you should rush out and do it. Buying long term put options is risky, and there’s a legit chance you could lose all your money. In something like Amazon, where lots of people are looking to short, premiums are expensive. Do this at your own risk. But if you get the call right, options will give you a terrific return.