One of the biggest things that I love about trading and investing is the massive amount of creativity that’s involved. Typically, when people think of trading and investing what comes to mind is probably some Wall Streeter in a Gordon Gekko suit and tie, or an excel spreadsheet with a bunch of numbers and gibberish. People tend to think trading and investing is boring, and mechanical.
The reality is that trading and investing is anything but boring and mechanical. Trading and investing are immensely creative endeavours. In fact, I’d argue that if you lack creativity, it is impossible to reach the upper echelons of trading and investing success.
What makes trading and investing so creative? To me, the creativity is in how you decide to capitalize on an opportunity.
For instance, if you have a Short bias on a Stock, would it be better to Short the Stock or sell a Call Option?
If you know what selling a Call Option is, I think it’s pretty safe to say that you know what shorting Stock is. For the uninitiated, shorting Stock is merely the opposite of buying Stock. When you short Stock, you borrow shares from someone else and sell them.
You then buy back the shares at a lower price for a profit, or you buy back the shares at a higher price for a loss. Either way, you’re going to buy back the shares at some point to repay the borrowed shares. Here’s a video that explains shorting Stock visually:
Things To Keep In Mind When Short Stock
When you short Stock, your maximum upside is contained to the price of the Stock at which you shorted it at. For instance, if you shorted Stock at $100, your maximum earning potential would be $100 per share, because the lowest the Stock can go $0.
Your maximum downside is unlimited. That’s because the Stock’s price can theoretically increase in value into perpetuity.
The silver lining here is that, more often than not, when a Stock falls, it falls. Opportunities to short a Stock can pay off bigtime, because as the expression says the market takes the stairs up and the elevator down. Shorting Stocks can be a great way to make money fast.
When A Stock Is Hard-To-Borrow (HTB)
Not all Stocks can be shorted. Moreover, Stocks that can typically be shorted might be hard-to-borrow (HTB), if there is an influx of short selling. This can be an unfortunate situation, especially when there is a very good opportunity to short.
In an event like this, you could always buy a Put Option. However, a Stock’s Options Market might not be as liquid, and as a result the Bid/Ask Spreads might not be as tight as they would be in the Stock itself. In other words, by buying Puts instead of shorting Stock you run into the risk of losing money purely on a wide Bid/Ask Spread.
Selling Call Options
Selling Call Options can be a great way to increase your probability of profiting from your bias, or reducing the basis on your Long Stock positions. The use of Options is where trading and investing can get very creative. Buying and selling Stock is very binary. You are either Long or Short. When you add Options into the mix, you can be simultaneously Long and Short the same underlying Stock.
When you sell a Call Option, instead of shorting Stock, you increase your odds of profiting. This is because, typically, you sell out-of-the-money (OTM) Call Options that have a high probability of expiring worthless.
In terms of risk/reward, selling Call Options is very similar to shorting Stock. Your upside gain is still capped, and your downside loss is unlimited. However, your upside gain is limited to the premium that you sold. So, in other words, if a Stock dropped from $100 to $0, you would only make the premium that you sold the Call Option for, not the whole $100 per share.
However, like I said, you odds of making money to begin with are statistically much higher than if you were to short Stock.
One of the other advantages of selling Call Options is that you’re taking advantage of Theta Decay (also known as Time Decay). Options are depreciating assets. The closer an Option gets to expiration, the less valuable it becomes and the quicker its value depreciates. Theta Decay is what allows for selling OTM Options profitable.
Why Not Buy A Put Option Instead?
You could, if you wanted to. It’s your account after all. But it depends on your goal, and what you think a Stock might do. In the case of a Stock being hard-to-borrow, you could buy a Put. However, like I laid out above, be careful with the wider Bid/Ask Spreads.
Also, when buying a Put, you are subject to Theta Decay. The longer you hold that Option, the more it depreciates and the faster it does so.
When You Might Want To Short Stock
Identify what you think a Stock is likely to do. If you think a Stock is likely to make a large downside move, you would benefit by the higher upside potential with short Stock, over selling Call Options.
Moreover, if you want to keep things simple, shorting Stock is the simplest way to take advantage of downside moves.
When You Might Want To Sell Call Options
If you’re marginally bearish on a Stock, but you think prices are going to grind lower rather than drop like a rock, selling a Call Option is a great way to take advantage of slow moves to the downside without getting chopped up in erratic price movements.
If you are Long Stock and would like to reduce your basis on the trade, selling Call Options can be an excellent way to achieve this. Or, if you don’t own any Stock, and don’t want to take one the margin requirements of short Stock, you can sell Call Options to take advantage of Theta Decay.
As you can see, there’s many ways to skin a cat. Trading and investing is truly a creative endeavour, that allows those with the knowhow to profit in many different ways. For those of you who are looking for more on how Options work, check out our free course below. Thanks for reading.