The Very Best Way to Short

admin (June 24, 2010)

Expanding Your Investment Options: How to Make Small Bets With the Opportunity for Big Gains

Although I got my start investing in silver and stocks, it wasn’t until age 17 I got my first “job.” I worked at a grocery store for over two years.

The day I turned 18, I was promoted to the meat department. For a guy who loves steak and shrimp, it was a dream come true (except for the extra loads of laundry to get rid of the smell of fish). And it was a lot more comfortable to work in 40-degree refrigerator all summer than to collect shopping carts from the parking lot.

I never planned to work there full-time—I was focused on school. But by default, I ended up doing so when my coworker sliced his thumb off one morning on a meat slicer.

His carelessness allowed me put in 40+ hour workweeks.

And this story is a lot like investing: You have to keep your wits about you, be ready to move to safety and, most importantly, be trained in the right tools for the right job.

Just as my career started simply—bagging groceries—and has moved into increasingly complex areas, so has my investment style.

And in today’s crazy market environment, you should add to your investment skills, too. You never know when they’ll come in handy.

When Simple Isn’t the Way to Go…

I’m not going to lie. When it comes to investing, I like to keep things simple.

That usually means buying shares of stocks for the long haul—the kind of investment where, over time, my returns will be ultimately decided by how sound my analysis of a company ended up.

But when it comes to shorting, I don’t use the plain-vanilla approach of borrowing shares from my broker, which is the traditional (and riskier) way to go short.

Unfortunately, that’s no way to make a fortune on the short side. Which is why, with shorting, I recommend that you buy put options.

Unlike actual stock shorting, put options give you the opportunity for more than 100% upside … without any of the risks that come with actually selling shares short.

To see why, think about the act of shorting itself: You have to borrow shares, you’re limited to 100% upside (if the shares drop to zero), and you’re subject to having the shares recalled at any time.

Add since the market has an upward bias, it sounds like shorting is nothing more than a surefire way to lose money.

But what many investors don’t realize is that, even in an uptrending market, certain individual stocks are always hitting the skids – whether it’s because the sector is performing poorly as a whole, or a company itself is missing the mark when it comes to weak earnings, products or management.

In fact, there’s nothing I enjoy more than making short-side profits when “everyone else” is bullish.

And not just scalping a few percentage points here and there – I’m talking about banking double- or triple-digit gains over the course of a few days, weeks or months when it seems that the rest of the market has its back turned.

And I do this regularly, in any market conditions, with options.

A Closer Look at the Mechanics of a Bank Short

Here’s one example of using a put option on a bank stock. A play like this delivered a 50% gain in 15 days to my Credit Crunch Short Report subscribers:

Say you think that next earnings numbers from FifthThird Bank (FITB) will miss in a big way. Buying a few deep in-the-money puts before the earnings announcement could make you triple-digit gains.

Here’s how: FITB’s next earnings announcement is July 22. You can buy options today that expire in August, a few weeks after the earnings. (A lot of bank earnings are close to option expiry dates, which can get dicey.)

Your put options choices for August FITB are as follows:

See the highlighting on options above $14? Those options are in-the-money. That means the share

prices are already below what you’re shorting them at. Your could be more speculative and use out-of-the-money puts, which can gain more on a percentage basis, but carry a lot more risk.

And it does all come down to how you want to manage your risk. With in-the-money options, the share prices could turn against your position, and you’d still have a buffer of safety. The option would still lose value, but it would reduce the likelihood of becoming completely worthless.

I like options that are at-the-money or are slightly in-the-money for my CCSR recommendations, but let’s have fun and speculate (something I’ll probably do with bank stocks following the end of stimulus from the Fed and housing credits).

Say you like the $5 puts, which is a bet that the stock will drop to $5 during the life of your option contract.

Now, the odds of the stock falling over 60% between now and late August are probably about as likely as the odds that I’ll trip over a gold brick.

But it doesn’t have to fall that far for those $5 options trading at $0.04 to move to, say, $0.12— a threefold rise!

You could probably even see a double in the $10 or $11 options if their earnings numbers for July were bad enough.

You wouldn’t be able to put too much money into the trade at those prices—which is both an advantage and a disadvantage. You’d be limiting your risk, with the potential for outlandish gains, but your overall portfolio might not have that big a gain. Remember, each option is for a round lot of 100 shares, so a 4-cent option would really cost $4— clearly, a much cheaper way to short 100 shares without having to borrow them!

But trying to take advantage of bearish moves in stocks with shorting would be like trying to trim your fingernails with a meat slicer.

That’s why options, when used right, can be a useful tool—especially when there’s the possibility for quick gains on the short side.

See you on the short side,

Andrew Packer
Editor, Credit Crunch Short Report

P.S. I’ll be opening my Credit Crunch Short Report to accept new subscribers in the coming weeks. For more information now, you can call my team at 1-866-584-4096. In the meantime, Sovereign Society Members will receive my latest short recommendation in The Sovereign Individual on Saturday when the July issue hits your inbox. Not a Member? Click Here to learn how you can download the July issue this weekend and take advantage of a unique short play for 20-30% gains. Plus, an exciting (safe) play on the China growth story.

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