Tuesday, January 14, 2014

Thinking of shorting a stock making all time highs?

Shorting stocks that are making new highs can be very risky. Nevertheless, many undertake this strategy to try and profit when the stock tops out. And obviously if you are able to get short at that point and catch a significant downward move, profits can be very large. But it is nearly impossible to know when this will happen (indicators notwithstanding). In the mean time, losses can mount as a stock that looks 'top-heavy' continues it's meteoric rise. Is there a better strategy? How about an option straddle? A straddle is the simultaneous purchase of a put and call at the same strike price with the same expiration date. And since Implied Volatility, which affects option pricing is typically lower as stocks are rising, straddles can be bought for favorable pricing. If the stock continues to make new highs during the life the straddle you can profit on the call side, while if it does reverse significantly, profit substantially on the put side. And you're only risking the price of the straddle vs the margin required to sell short. The worst case scenario is that the stock flat lines, which would be very unusual for such stocks. Following is an example using Apple Computer, which reached an all time high of 705 in September of 2012 shown on this weekly chart:


Implied volatility (IV) of Apple call options reached a low in late July of 2012, as seen on this chart:

A 6 month straddle purchased at this time would have put options in place as Apple computer subsequently fell nearly 300 points (certainly large enough to cover the losses on the calls). Straddles purchased at previous IV lows would have likely profited from the continued rise of the stock. There are many more nuances to be understood about trading straddles, but they are certainly a viable alternative to to short selling stocks making new frequent highs. (Charts created in Metastock)

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