Creating Viable Double (Triple) Shorts and Longs

Several people have asked me to explain how to set up a double-short or triple short that works. At the risk of being verbose and still incomplete, here is a quick discussion on how to do it. Remember, anytime you are learning something, set aside "tuition money" and only play with that amount until you grant yourself a diploma.

Let's start with an example of a double-short position that clearly didn't work: SKF (double short financials)

October 2007 - $80/share
April 2009 - $59/share

What a crime. One reason is obvious, up-moves can be higher in percentage terms than down-moves of the same size, see: http://fdralloveragain.blogspot.com/2009/04/msm-stocks-up-25.html.

So how do you set up a double-short that works? There are an infinite number of ways to achieve this goal using long (purchased) and short (sold/written) options, or combination of both. For the purposes of this discussion, I'm going to assume little options knowledge to keep it simple and straightforward.

First, options are not for everyone - blah blah blah - disclaimer. But there is a GOOD reason that options are not for everyone, they are generally a scam, just like the stock market. The reason they are a scam is because 80% of contracts (so the anecdote goes) expire worthless. What does that mean? It means 80% of contracts returned 100% profit for the options writer(s) and a 100% loss for the contract buyer(s).

Side note - that does not always mean the option buyer "lost." Intelligent option buyers may buy contracts to hedge or insure larger positions. In other words, just because your house didn't burn down doesn't mean purchasing an insurance contract was money poorly spent.

In other words, the house has a tremendous advantage on the majority of options contracts written. There are two lessons here: (1) don't rule out writing (sell/shorting) options contracts (being the house)--stats show it is the way to go. This usually requires meeting minimum equity requirements or covering the position. (2) if you elect to buy, try not to dwell where most options contracts are written: near the money.

I am not going to discuss (1) right now, because this article will get too long and the risk involved can range from extreme to much lower than simply buying the underlying stock/ETF. That said (1) is a place you should explore if you want to trade the market because it is where you can develop your largest advantage over those taking opposite positions. For example, buying any stock or ETF makes little sense in most cases compared to shorting a put at the money, but that's for another day.

So let's talk (2), (intelligently) purchasing options to achieve limited-risk leverage.

The first thing you'll notice when examining any options chain is that your broker, or price quoting service, will almost always start by flashing up options that are "near the money." That is because these options are the ones where the buyer (you, in this case) has the largest disadvantage. Buying options near the money can be great money makers in rare cases, but like I said above, they lose about 80% of the time if held to expiration.

Let's start with why most options buyers lose:

1) Options sell at very high premiums that often offset gains
2) Most options buyers are unsophisticated, lottery-type gamblers
3) Options incorporate a time element in order to win

We are going to reject ALL of those paradigms when creating positions.

What is an option? It is a derivative. What is a derivative? Essentially, any third party legal contract written between people where the outcome is derived from some other market behavior. It is "side-show gambling," "off track betting," or, for those who don't like negative labels, "insurance underwriting."

Options are simple:

The option-buyer purchases the legal right to buy or sell shares of an underlying stock (or ETF, commodity,etc.) at an agreed-upon price, at an agreed-upon time.

A Call is an agreement to buy a symbol at a certain price (called the strike price) and time in the future. A Put is an agreement to sell the symbol at a certain price and time in the future.

That's it.

The buyer of the option contract hopes that a positive price differential develops during the given time period. The seller or writer of the option contract hopes that no differential develops, or if one does, that the sales price of the contract more than covers it.

A quick example:

Jane wants to profit with leverage if IBM stock goes up. Perhaps she is hedging a majority-short position. Maybe she doesn't want to commit a lot of money into a shaky market. Or, maybe she is a gambler who just likes the leverage.

Bob thinks IBM is going nowhere.

So Jane and Bob pay a someone to broker a Call contract. The contract states that for a fee of $13, Jane may buy 100 shares of IBM stock at a price of $100/share (the Strike price) on or before the third Friday in January 2010.

The actual symbol for this Call is +WIBAT

Here is what might happen:

Let's say that on January 15, 2010, IBM stock price is $111.

Jane was right, IBM stock went up. She is able exercise her option contract (or sell it to someone who will). She can now buy a stock worth $111/share for $100/share. Profit: $11/share.

So, Bob won. Bob charged Jane $13/share, he only had to pay her $11.

Note, in our above example the contract did not expire worthless, so it isn't in the 80% statistic, and the buyer still lost. If IBM closed at $94.68 (anything less than $100.01) on January 15, 2010, Jane's Call would expire worthless.

For those interested, I'll will cut and paste to create the "Put version" for reference:

Jane wants to profit with leverage if IBM stock goes down. Perhaps she is hedging a majority-long position. Maybe she doesn't want to commit a lot of money into a shaky market. Or, maybe she is a gambler who just likes the leverage.

Bob thinks IBM is going nowhere.

So Jane and Bob pay a someone to broker a Put contract. The contract states that for a fee of $11, Jane may sell 100 shares of IBM stock at a price of $100/share (the Strike price) on or before the third Friday in January 2010.

The actual symbol for this Put is +WIBMT

Here is what might happen:

Let's say that on January 15, 2010, IBM stock price is $91.

Jane was right, IBM stock went down. She is able to exercise her option (or sell it to someone who will). She can now sell a stock worth $91/share for $100/share. Profit: $9/share.

So, Bob won. Bob charged Jane $11/share, he only had to pay her $9.

Why did Jane lose? She paid too much for a fundamentally correct position. Keep in mind, it doesn't matter if you are right or wrong, what matters is that you make money.

With that quick lesson in mind, let's create a double-short on the Dow, right now. We want a position that will produce roughly 2% for every 1% of downward movement. An ETF that tracks the Dow (divided by 100) is DIA. If we buy a DIA Put, we should be able to achieve our goal. Let's find the right Put.

Right now, DIA is selling for $80/share (Dow 8000/100). Let's use a 100 point move lower as a test parameter. If I buy DIAQF (the right to sell DIA for 110 on May 15, 2009) it costs me about $30. If DIA drops to $79 (i.e. the Dow fell to 7,900), my Put will go up by $1.

My return?

Base ETF moved from 80 to 79, a loss of 1.2%
DIAQF goes from from 30 to 31, a gain of 3%

We have created our double-short.

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Notes:
- As the index moves in the desired direction, leverage decreases somewhat.

- Subtract the cost of the option from the (strike price - symbol price) to asses all fees. The difference between the option cost, and the straight difference, is the total premium you are paying for the option should you hold it to expiration. By staying "well into the money" (strike price of 110 while the symbol is trading at $80 is a full $30 in the money) the premium paid for the option contract can be reasonable.

- Options trade in lower volume than stocks, so you will typically pay the Option Broker and the Options Exchange about 5 cents per share per contract (a total of about 10 cents per share per contract) in addition to your own broker fees. This is another reason to stay well in the money, since 10 cents per contract is a much lower percentage of a $30 Put than a $5 Put.

- For the purposes of this post, buying a Put or a Call option contract (not writing them), one would "buy-to-open" then "sell-to-close."

- Total risk when buying a contract is 100% of the capital placed at risk, much like buying a stock, but with some amount of additional leverage to accelerate losses or gains.

- American options exchanges allow selling option contracts, at current market value, to another person at any time prior to expiration. This includes both long and short positions. Much like stocks.

- For those interested in better understanding the current financials meltdown:

Imagine selling (not buying) Puts on real estate prices for years and years and years on end to generate cash flow from premiums. Real estate prices "always" go up, so your Puts "always" expire worthless, granting you, the derivative seller, the entire premium someone else paid to purchase your Put.

This is called selling "insurance." (perhaps your firm's stock symbol is AIG or BSC or GS?)

Since the risk of a 20% real estate meltdown was assessed to be very low to impossible, let's say that you were able to sell $80 (strike price) Puts on an existing $100 price basis for something like 2 cents per contract. Essentially, you are agreeing to insure losses below a 20% decline, matching them dollar for dollar starting at $80, for a fee of 20 cents.

Year in and year out, you pocketed your whole 2 cent premium, pure, 100% profit. So easy was the money, that your infinitely-stupid culture evolved to assess sucha deal as "risk free money."

Then, oops, some real estate prices fell 70%.

Your total loss exposure? The media would have you believe is perhaps 100%. It is not. It is the current real estate basis price of $30 ($100 after a 70% fall) subtracted from your insured (strike) price of $80, over your per contract sales basis of 2 cents each, or $50/$.02 -- a loss of perhaps 2,500 times your company's usual income -- a margin call machine.

Now you know a key reason why "bailing out" these so called investment banks, banks, and insurers is a never ending money pit.

Only the government is dumb enough to buy these contracts from them. The free market price to transfer the risk is $0, not because no one in their right mind would pay for a worthless contract, but rather, no one in their right mind will pay money for a 250,000% liability. Except you, the government, or so they think.