How to Short Stocks with Zero Downside

How to Short Stocks with Zero Downside

Short stocks, generally referred to as short selling, is dangerous. If the stock is reduced, the upside is limited to 100 percent (the value of the short one); the downside is potentially infinite as the stock will grow to multiples.

Moreover, financial assets basically “need” to be priced over time to make the overall system function effectively where private investors lend, invest, and build trust. Central banks are making capital over time, and a lot of it ends up in financial assets.

Shortening is inherently challenging in stocks and other financial assets since these secular forces are operating against you.

Management teams are also manipulating the narrative.

For those who started shortening Wirecard in 2010, over the next 8 + years, the stock increased by almost 30x (or close to 3,000 percent). Along with the myth that it was Fintech’s success story and its fraudulent accounting that skewed its financial health. German authorities focus more on the interaction between short-sellers and the media than on specific questions regarding their financial statements.

It took a really long time (and pain) for those who were right about the issues of the company to pay off with regular short stocks. Those who can’t handle a short place going up by multiples get the “squeezes” out.

(Source: Trading View)

Shorting was risky considering the strength of the stocks.

Momentum, as a tactic itself, attracts some market investors who buy and sell stocks for no reason other than the direction in which they are currently heading. Markets tend to run in trends and “trend-chasing” is a tactic practiced by many (e.g. CTAs and other quantitative traders) even though it has little to do with the underlying dynamics of the market.

Moreover, a lot of Tesla’s stock is directly related to the underlying demand for options. If there is a lot of open interest in the market for options, market makers will hedge their short call and expose them to the prospect of buying or selling these stocks.

For example, if there is a high demand for call options, the market maker will underwrite the option. Due to the infinite downside risk structure associated with a short call, the market maker usually needs to purchase the stock in some portion (e.g. delta hedging) to ensure that the risk of the trade is properly controlled.

Buying stocks raises the price, keeping everything else stable, even though it is merely a technological element that has little relation to the fundamental health of the company.

If the stock increases, the delta will also rise, incentivizing the additional purchasing of the stock. This generates momentum-related movements that feed on themselves.

So, for a trader looking to bet on a company’s share price down, they may think that the risk/reward of stocks shortening is out of hand and avoids it.

They may also switch to long-term options.

In principle, purchasing options is good because of the small risk and the broad upside value of the trading structure. Not necessarily in terms of the predicted benefit, but in terms of “what is probable.”

With options, however, all comes at a price. They could be costly.

Let ‘s say that you’re agnostic about timing for the short one and want a long-dated alternative. As a consequence, the theta decay on the option will not be so extreme.

For some of the liquid, common stocks, you can leave 2-3 years in the future if there is enough demand for them.

For Tesla, since a lot of people don’t want to shorten their stock because of the risk, they have the same idea of expressing a short thesis through a collection of options. This phase also provides higher premiums in the options market.

For example, the September 2022 1000 costs up to $198 per share.

Your upside down on the short, $0 stock, is only about 5x. Options contracts are in-the-money (ITM) at $1,000 per share and there is a premium of ~$198 per share. In this case, Breakeven is around $800.

If the option is out-of-the-money (OTM) by expiration ($1,000 per share or more), it expires without benefit.

There is also a broad range, ranging from $182.50 to $198.00, which is typical in options markets that are generally less liquid than the underlying stock. It’s a transaction that can be difficult to make in terms of scale for larger investors.

But the risk of “losing everything” on the options bet can be tempered in a few different ways:

i) Hold a small position compared to the size of the equity in your portfolio

ii) to finance it by coupon payments in a separate section of the capital structure of the company;

Tesla, too, has bonds.

Right now, they ‘re offering a little less than 4 per cent annual yield, around 3.8 per cent.

If you owned $100,000 worth of bonds, they would generate about $3,800 in revenue each year if the company did not default on them.

The profits earned on the bonds must be equal to the length of the trading options.

Since the example being used is a two-year option, you would have earned a two-year bond coupon payment.

That would be $3,800 in annual vouchers multiplied by two, or $7,600.

That $7,600 could, in turn, finance the short side of trade by offering options by buying up to that amount of options premium.

This has a few advantages:

i) If everything goes well for the company, and the short thesis doesn’t work out, and/or the stock rockets are higher, you won’t lose anything. The put options run out of cash, but you got the coupon payments on the bonds. It’s going to net out to a wash.

ii) If a company’s bonds are defaulted on, it means that there are some significant equity issues. The shareholding in a corporation is the youngest in the capital structure. This ensures that the owners of a company are paying last after all costs (including fees to bondholders) have been charged.

In the case of a liquidation default, common shareholders are compensated last. They also receive nothing while bondholders (also known as creditors) can receive some of them being seniors in the capital structure.

When bond payments cease, this means that the stockholders can be zeroed and that one of the rights for selling is likely to break out.

There is a high chance of risk on the stock market. For example, Hertz’s essentially worthless stock rose 10x after he declared bankruptcy. Equity being as bad (typically worse) than bonds in the “implosion” scenario is generally something you can rely on.

With $7,600 in revenue to be used for put options, you might buy a long-term 100 bet (approximately 96 per cent OTM). They are highly convex and well adapted to someone who may assume that a organization is not inherently worth anything.

They ‘re currently selling about $560 apiece.

With $3,800 worth of money, you could buy 14 set options ($7,600/$560 = ~13.6) rounded to the nearest whole number. Or 13 contracts added up to ensure that the total sum of funding is provided.

Downside down

If the business does at least all right, you ‘re going to get paid on the bonds even though the put options expire worthless.

It may also be the case that the bonds are defaulted on and the stock stays above the option strike price. It’s impossible, but it could happen potentially.

However, generally speaking, if the bonds implode, the stock would probably implode as well. The creditors are senior holders of equity.

Upside down

If you bought 14 bid option contracts at a price of 100 hits, the reward is $140,000 (14 contracts multiplied by 100 hits multiplied by 100 shares per contract) minus the total cost ($560 per bid option contract multiplied by 14, which is $7,840). Ok, around $132,160.

If the bonds were to default, you might be out as much as your $100,000 investment minus any coupons got.

In the case of default where the equity is zeroed, even though you had zero bond recovery, you will still get $32,160 plus any bond coupon payments earned. (This is based on the stock market understanding the truth of the situation, which is not always a guarantee.)

Recovery rates are usually 40-75 cents on the dollar in bankruptcies for unsecured creditors but differ on a case-by-case basis.

In the event the prospective loss on the bonds swamps the prospective gain on the options, some of your choices are:

i) Do not enter into trading until you have a higher bond yield to afford the cost of additional option premiums.

ii) Buy cheaper options that offer a more convex structure and potentially improved payout. This is not always possible, however. On top of that, the more choices you have, the lower the chance of receiving a return on them.

iii) Buy more options contracts to protect your future bond downside. This comes at the expense of suffering a loss in the “smooth sailing” situation for the company because the premium incentives would outweigh the discount payments. Namely, if the expense of the option premium is greater than your prospective overall bond payments, you will lose money.

Overview of the stock

In this post, we covered a reasonably safe way to express a bearish opinion on the stock.

Markets can switch to places they’re not supposed to go for reasons that don’t make a lot of practical sense. This could make regular equity shorts risky. This is particularly true for a stock or general market that goes off script and/or a management team who is really interested in seeing their share price appreciation.

You can take a different method instead of shortening the stock directly, where you’ve set upside down and infinite downside.

If a company sells bonds that have a fair coupon attached to them. You can take long bonds and simply use the proceeds from bond coupons to cover the expense of selling options used to shorten the stock.

If the trade doesn’t work out, you’re going to have for zero gains and zero losses. Bond coupon payments offset the costs of the put option premium.

Few businesses have high bond yields in today’s world. However, companies that are the best shorts prefer to have a better return on their investment – they are riskier.

The bond market appears to do better than the stock market for pricing risk. The former (with its fixed upside) is more oriented on cash flow and risk than the stock market, which is all on how positive things can be achieved.

Annual bond yields of 3-5 percent are usually appropriate to buy OTM put up options that give up if the short thesis does not result in an unreasonable downside.