Mon Mar 27, 2006: What To Do When You Get Caught Short

Speculative options trading can lead to both quick profits and quick losses.

Handling profits is easy; you don't have to do anything. When a trade unfolds as expected you can just let it play out. But what should you do when a trade starts to go against you?

The worst thing to do is nothing -- just sit there and let it get worse. This leaves you in the opposite position as that above. In this case someone else is just letting it play out, and you're the loser, on the other side of the trade.

One thing that separates successful traders from others is how they handle their losses. The old adage is to take care of your losses and then the profits will take care of themselves.

Fortunately for us option traders we have many more tools at our disposal than stock traders have. We can trade both the stock and the options, and with options there are various strategies we can employ.

But the first thing to remember is to act quickly and decisively when a trade starts to go against you. Without remembering that, no strategy will help you.

Why is it natural for us emotionally to just sit there and hope that a losing position will turn around? Because prior to making the opening trade, we did a lot of research and analysis, and we expect to be right. But nobody is right about every trade. 50% is more than good enough if you cut your losing positions short and add to your profitable positions.

Inexperienced traders get upset when a trade starts to go against them, and refuse to take a loss, hoping for the market to turn around and prove them right. Even if they accept the possibility that they might be wrong, they fail to act because due to their analysis they are afraid that as soon as they close or reverse their losing position, the market is likely to swing back the other way, proving them right but hitting them with an additional loss if they reversed the position, or at least forcing them to miss out if they just closed the position.

Experienced traders do not get upset in this circumstance.

They get excited.

Why? Because they know that if after all their research they are still surprised by the market, then something new and big is starting. Not only do they have no interest in fighting it, they want to join in and get their share!

First accept that yes, getting whipsawed back in the other direction is a possibility and sometimes it will happen. But so what? Realize that the probability is it won't happen because the market trends more than it oscillates. If only it were the other way around our lives would all be easy; we could just buy low and sell high again and again within a perfect trading range, but that's not the way the market works. So most of the time it's more likely the stock will keep moving in the new direction that has surprised you.

Making money is not about being right; it's about trading in the direction of the market. Traders are never really right or wrong. Only the market is right or wrong, and when it's wrong it often corrects itself violently. Never argue with it. If you are surprised by a sudden change of trend, you will not be the only one. Sudden unpredictable factors come to light and surprise all traders at the same time. Some deny reality and try to fight it. The winners learn to quickly go with the flow. Remember you are not alone. Others are in the same position. What are they doing? Some will sit there and let it get worse. If you want to win, you have to take action.

Being caught short a stock that is skyrocketing can be frightening, but the solution is simple. Buy it back. Now. At the market. Don't play with limit orders being penny wise and pound foolish. Remind yourself that you are one of the few traders willing to take quick decisive action, although it might prove in this one instance to be a mistake, most of the time it will not.

Now consider going one step further, and after covering your losing short position actually taking out a long position in the same stock, giving yourself a chance to recoup your losses and actually end up with a profit by going with the flow of the market in the new direction. The sooner you do this, the more likely it will turn out to be a profitable choice. And your original analysis might still very well prove to be correct; perhaps just your timing was wrong. For now, make money in the new direction for a while, knowing that eventually the market may change and you'll be able to try your original short trade again, from a higher entry point and with a little more money in your pocket to start!

Another approach to handling a short position running up against you is to place a stop-loss buy order above the market. The drawback to this approach is you are not guaranteed to be filled at your stop price. If you are short a stock at 37 with a stop-loss at 40, and the stock opens at 45 the next morning you will get filled at 45 or slightly above that. And if you placed a "stop-limit" order at 40 you will not get filled at all. By the time you realize what is going on the stock could be at 50 or higher. I do not recommend stop-limit orders for closing out losing positions. (I do think they can be useful for opening new positions). I recommend using "stop" orders, which automatically become a market order once any trade occurs at the stop price.

Safer and more powerful than using a stop loss buy order is to buy an out-of-the-money call option as soon as you short the stock. This will cost you some extra money up front but if you really expect a large drop in the stock you might be willing to buy this "insurance" as a cost of doing business. The market can never gap up around your call option. You completely own the right to buy the stock back ("call" it away from someone else) at your strike price no matter how high it gaps up. So this is the ultimate "sleep at night" hedge for a short stock position.

Whenever I suggest hedging a short stock position with a long (purchased) call option, two questions inevitably arise.

First, the option writers I'm talking to shake their heads and say no way, I'm a smart seller of options, not a dumb buyer, don't you have any way to hedge by selling options instead of buying them? Well yes of course I do, but your premise is false, the premise being that writing options is always far superior to buying them. That's not true. It's just a different strategy. Sure, more options expire out-of-the-money than in-the-money, but the ones that do go in-the-money can provide overnight profits of 100% (double), 200% (triple) or more to the option buyer, while such returns are very hard to come by for an option writer. Usually as option writers we're looking to make in the neighborhood of 5% to 10% per month.

So while the odds of winning are superior for option writers, the payoffs when winning are superior for option buyers. In the long run it tends to even out. So be flexible with your choice of strategy, tailoring it to the specific situation. Or, if you prefer to stick with only one strategy, be very careful with your stock selection and timing. Don't just blindly apply the same strategy over and over again expecting it to work in every situation. It won't, no matter how great you may feel your strategy is.

Understand that there is always somebody on the other side of your trade. For example, when you confidently buy a stock and sell a covered call, there is someone selling you the stock and someone buying the call from you, and it might be the same person! Think about that.

The second question that usually comes up is this: If you're going to short a stock and buy a call, isn't that effectively the same as simply buying a put? The answer is yes, almost, if the strike price is right at-the-money. But if you buy an out-of-the-money call then you are paying less premium than buying an at-the-money put, and your short stock is still "at-the-money". You are still expecting the stock to go down; the put purchase is only for insurance in case it doesn't.

Also, you don't have to buy the same number of calls as you are short stock. That is, if you are short 500 shares you don't have to buy five calls to hedge. You might buy only three, accepting the possibility of a big loss on the unhedged 200 shares in return for a lower cost of insurance.

On the other hand, in the case of a stock that you expect to either break down badly or soar sharply based for example on an upcoming news item, you might decide to buy more than five calls. This effectively would automatically take for you the action described earlier - covering your short position with a limited loss and also reversing it into a long position, should the stock suddenly soar.

OK, but what about using option writing strategies to hedge a short stock position? Well you can do that right away by selling covered puts as soon as you short the stock. This will provide some income right away, which will slightly offset your loss if the stock starts to go up because the puts will decline in value and expire worthless if they stay out-of-the-money.

Most people tend to always sell out-of-the money puts, thinking that they want to make a profit from the put income in addition to the stock going down a little (just like a covered call writer does in the opposite direction). But some people sell at-the-money covered puts or even in-the-money covered puts versus their short positions. Why would they do this? Think about it for a while, and look carefully at the Covered Puts 1 and 2 tables on the home page of this site. You might be surprised to find that often at-the-money or even in-the-money covered put writing can be almost as lucrative as out-of-the money, with less risk because you receive more premium up front which acts as a bigger hedge if the stock starts moving up. Use the tables, that's what they're there for.

Again with covered puts, you could sell fewer or more than your short shares. If you're short 500 shares you could sell five covered puts and five uncovered puts for extra income. Of course the extra five would be naked puts. Consider thinking like a market maker, being willing to get put out of your short position at a nice profit on the way down and put into a new long position for a possible swing back the other way. If you want to take this approach, you might sell five puts at-the-money and the extra five out-of-the-money, so that if you do end up buying the stock long you will do so only at a steep discount to the current price.

If you are short 500 shares of stock you might sell only three covered puts, leaving yourself open to the possibility of riding the 200 uncovered shares further down for a big profit.

What if instead of shorting the stock outright, you chose to sell naked calls to establish your negative bias on the stock? What can you do if the stock starts shooting up? One thing you could do then is to place an order to buy back the calls at the market. Or, you could place such an order in advance, as a stop-loss buy order.

I don't recommend either of those two approaches. Options are much less liquid than stocks and wide price swings can easily cause your stop to be hit, especially since option market makers / specialists are not always honest. (There, I went ahead and said it!) Placing a stop order in the options market is just too tempting for them. And if you try to place a regular order to buy back your call options after a stock has already started running up, you will be paying a high premium.

I prefer instead to simply buy the underlying stock in this case, hopefully before the naked calls get in-the-money. By doing this, you can get a good fill at the market in the more liquid underlying stock without paying an option premium, and you can essentially convert your naked call position into a covered call position. Once more, you don't necessarily have to cover all of the naked calls. Often if I am short say 10 naked calls and the market starts shooting up, I will buy just 500 shares of the stock at the market and sit tight on the other five naked calls.

Also I tend at this point to sell five offsetting naked puts, which require no additional margin versus the five remaining naked calls. Then I wait it out. Think about that strategy for a while. What you actually have then is a covered call position plus a naked "strangle" (or "straddle" if the naked puts and naked calls are at the same strike price). This is one of my favorite positions.

But let's save strangles, straddles and spreads for another day. For now I hope I've given you a few ideas to ponder. As you consider these approaches, look more closely at the tables than you might have up until this point and work through some new possibilities that might become visible to you now.

Two more points before I go.

Whatever you do to take action when a trade starts to go against you, you don't have to do it all at the same time. For example, if you are short a stock and it starts going up sharply, you might want to buy it back at the market to limit your loss, but then wait for the next dip to get long and go with the flow, instead of chasing it. If you are selling covered puts and the stock starts going up, you could sell more puts then, and still more at a higher strike after it goes up more. It all depends on the individual circumstance. In general, it pays to be as flexible as possible, trying not to forecast the market but rather to go along with it. Let others try to forecast it and try to fight it. That can be lots of fun and very exciting, but usually not very profitable!

And finally, realize that most of these strategies require you to have some extra money in your account on the side that you are holding in cash. Or in the case of a margin account some extra buying power that you are not using. Always keep some extra set aside. Inexperienced traders often end up losing money not because they are wrong or they are using a bad strategy, but because they get shaken out of the market with a margin call because they are over-leveraged. Always stay under-leveraged. This way you can protect yourself when you are losing, and be in a position to take advantage of good opportunities when they appear.

Until next time, best of luck with your option investments!