Principles of Finance with Excel (Основы финансов c Excel)

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PFE, Chapter 22: Introduction to options page 20

market price S

. If along the way Cisco has paid any dividends, the short-seller will be

obliged to pay these dividends to the person he’s borrowed the stock from. His total

profit will be:

(

)

19.26

S Cisco dividends−+

[For more information, see the sidebar from the Motley Fool, one of our favorite websites.]

In the option chapters in this book, we will generally assume that stocks don’t pay any dividends

between the time you buy them and the time you sell them. This means that the profit from

buying or shorting a stock can be represented as follows:

ABCDEFGHIJK

Cisco stock price, 7 August 2001 19.26

: Market price

of Cisco,

21 September 2001

Stock buyer's

profit

Stock shorter's

profit

0 -19.26 19.26

5 -14.26 14.26

10 -9.26 9.26

16 -3.26 3.26

18 -1.26 1.26

20 0.74 -0.74

21 1.74 -1.74

22 2.74 -2.74

25 5.74 -5.74

28 8.74 -8.74

30 10.74 -10.74

32 12.74 -12.74

34 14.74 -14.74

PROFIT FROM BUYING OR SHORTING CISCO STOCK

Market price on 7 August 2001: $19.26

Assumption: Position liquidated on 21 September 2001

=A20-$B$5

=$B$5-A20

Profit/Loss from Buying or Shorting Cisco Stock

-25

-20

-15

-10

-5

0 5 10 15 20 25 30 35

: Cisco price on 21Sep01

Profit/loss

Stock buyer's

profit

Stock shorter's

profit

PFE, Chapter 22: Introduction to options page 21

The Fool FAQ : Shorting Stocks

Many times on the Fool boards I've seen references to `selling a stock short' or `taking a short

position.' Will someone tell me plainly what shorting is?

An investor who sells stock short borrows shares from a brokerage house and sells them to another buyer.

Proceeds from the sale go into the shorter's account. He must buy those shares back (cover) at some point in time

and return them to the lender.

Thus, if you sell short 1000 shares of Gardner's Gondolas at $20 a share, your account gets credited with $20,000.

If the boats start sinking---since David Gardner, founder and CEO of VENI, knows nothing about their design---and

the stock follows suit, tumbling to new lows, then you will start thinking about "covering" your short there for a

very nice profit. Here's the record of transactions if the stock falls to $8.

Borrowed and Sold Short 1000 shares at $20: +$20,000

Bought back and returned 1000 shares at $8: -$8,000

Profit: + $12,000

But what happens if as the stock is falling, Tom Gardner, boatsmen extraordinaire, takes over the company at his

brother's behest, and the holes and leaks are covered. As the stock begins to takes off, from $14 to $19 to $26 to

$37, you finally decide that you'd better swallow hard and close out the transaction. You do so, buying back shares

of TOMY (new ticker symbol) at $37.

Here's the record of transaction:

Borrowed and sold short 1000 shares at $20: +$20,000

Bought back and returned 1000 shares at $37: -$37,000

Loss: -$17,000

Ouch. So you see, in the second scenario, when I, your nemesis, took over the company, you lost $17,000...which

you'll have to come up with. There's the danger....you have to be able to buy back the shares that you initially

borrowed and sold. Whether the price is higher or lower, you're going to need to buy back the shares at some point

in time.

To learn more about short selling, try reading the following books: "Tools of the Bear: How Any Investor Can Make

Money When Stocks Go Down" - Charles J. Caes; "Financial Shenanigans: How To Detect Accounting Gimmicks &

Fraud" - Howard M. Shilit; "When Stocks Crash Nicely: The Finer Art of Short Selling" - Kathry F. Staley; "Selling

Short: Risks, Rewards and Strategies for Short Selling Stocks, Options and Futures" - Joseph A. Walker. None of

these are perfect in their coverage of short selling but each has its strengths.

Shorting, unlike puts, seems to have an unlimited downside potential, correct? That is, hypothetically,

the stock can rise to infinity. Puts, besides the time limit, have a limited downside. Why then, for a

short term short, would anyone short instead of purchasing puts?

Theoretically, yes. In reality, no. Because in our number system we count upwards and don't stop, we opine that

because numbers go on forever, so can a stock price. But when we think about this objectively, it seems kind of

silly, no? Obviously a stock price, which at SOME point reflects actual value in a business, cannot go on to infinity.

Yes, puts do have a limited downside. However, options have an expiration date, which means that they are "time-

wasting assets". They also have a "strike price" which means that you need to pick a price and then have the stock

below it on expiration date. Finally, you have to pay a premium for an option and if you are not "in the money"

more than the premium, by expiration day, you still lose. So, with options, not only do you have to be worried

about the direction of the stock, you need to be correct about the magnitude of the move and the time in which it

will happen. And even then, even if you successfully manage all 3 of these things, you can still lose money if you

don't cover the premium. Not very Foolish. With shorting, you only really need to be concerned about direction. As

for limiting liability, you can do that yourself by putting in a buy stop at a price where the loss is "too much" for

you.

PFE, Chapter 22: Introduction to options page 22

What is short interest? Does it have anything to do with short attention spans?

Pardon? Short interest? Oh yes! Ahem, short interest is simply the total number of shares of a company that have

been sold short. The Fool believes that the best shorts are those with low short interest. They present the

maximum chance for price depreciation as few short sales have occurred, driving down the price. Also, low short

interest stocks are less susceptible to short squeezes (see below). Short interest figures are available towards the

end of each month in financial publications like Barron's and the Investor's Business Daily.

The significance of short interest is relative. If a company has 100 million shares outstanding and trades 6 million

shares a day, a short interest of 3 million shares is probably not significant (depending on how many shares are

closely held). But a short interest of 3 million for a company with 10 million shares outstanding trading only

100,000 shares a day is quite high.

I've heard the term 'days to cover' thrown around quite a bit. Does 'days to cover' have anything to do

with short interest?

Yes, it does! Days to cover is a function of how many shares of a particular company have been sold short. It is

calculated by dividing the number of shares sold short by the average daily trading volume.

Look at Ichabod's Noggins (Nasdaq:HEAD)

. One million shares of this issue have been sold short (we can find this

number, called the short interest, in such publications as Barrons and the IBD). It has an average trading volume

of 25,000. The days to cover is 1,000,000/25,000, or 40 days.

When you short a stock, you want the days to cover to be low, say around 7 days or so. This will make the shares

less subject to a short squeeze, the nightmare of shorters in which someone starts buying up the shares and

driving up the share price. This induces shorters to buy back their shares, which also drives up the price! A short

days to cover means the short interest can be eliminated quickly, preventing a short squeeze from working very

well.

Also, a lengthy days to cover means that many people have already sold short the stock, making a further decline

less likely.

What effect does a large short coverage have (generally) on the stock`s price? Generally, heavy buying

increases the price while selling decreases it. Assuming the stocks price has been steady, or climbing,

and many shorters attempt to cover their losses, how will this affect the price?

What you are referring to, in investment parlance, is a "short squeeze." When a number of short sellers all try to

"cover" their short at the same time, that does indeed drive the stock up.

Our approach when shorting is therefore to avoid in general stocks that already have a fairly hefty amount of

existing short sales. We try to set ourselves up so we'll never get squeezed.

I'll point out that short squeezes can be the result of better than expected earnings or some other fundamental

aspects of a company's operation. They can also be the result of direct manipulation. That is, profit-seeking

individuals with large amounts of cash at their disposal can look on a large short position in a stock as an invitation

to start buying, driving up the share prices, thus forcing short-sellers to cover. This in turn drives up the price, and

before you know it, the share price has soared!

OK, I understand the potential benefits and risks of shorting, except for one thing. If the stock I've

shorted pays a dividend, am I liable for that dividend?

Yes. If you are short as of the ex-dividend date, you are liable to pay the dividend to the person whose shares you

have borrowed to make your short sale. I must say, however, that if you are correct in your judgment to sell the

issue short, your profits achieved thereby will certainly outweigh the small dollar amount of the dividend payout.

What happens if the stock I've shorted splits?

MF Swagman replies:

Let's say we're speaking of a two-for-one split. In that case, all that happens is that you must cover your short

position with twice as many shares as you opened it. If you shorted 100 shares, you must cover with 200. Don't

forget, though, that the magnitude of your investment hasn't changed, for while you now have twice as many

shares, each one is only worth half as much as before! So, while your original cost basis for the 100 shares may

have $36, now, with 200 shares, it is only $18.

PFE, Chapter 22: Introduction to options page 23

This is a very foolish question, I'm sure, but if I sell short I am essentially borrowing the shares from

someone else through my broker. Assuming that the lender does NOT need the shares prematurely,

what determines how long I can stay short? (pun intended) How long do I have before I am forced to

cover my position? Is there any regulation? Is it simply dependent on when/if the broker needs them?

Could I possibly stay short for an indefinite period?

As far as I know, there is no pre-determined limit to how long you can keep your short position open. Technically,

you could be forced to cover at any time, but typically, having the shares you have borrowed called back is

unusual. At least so state all the Schwab representatives of whom I have asked this question.

Source: The Motley Fool website, http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

PFE, Chapter 22: Introduction to options page 24

22.6. Option strategies—more complicated reasons to buy options

“Option strategy” refers to the profits which result from holding a combination of options

and shares. In this and the following sections we give a number of examples of such strategies.

Stock + put

We begin with a very simple (but useful) strategy: Suppose we decide, on 7 August

2001, to purchase one share of Cisco stock and to purchase a put on the stock with exercise price

20 and expiration date September. The total cost of this strategy is $21.26: $19.26 for the share

of Cisco and $2.00 for each put.

Such a strategy effective insures your stock returns by guaranteeing that on 17 September

2001 you will have at least $20 in hand. Your worst-case net profit will be a loss of $1.65:

Stock price

on 17

September

Strategy Cash in hand Net profit

Less than

$20

Exercise put option:

Give someone else your

share of Cisco for $20.

$20 $20 – ($19.26 + $2)= -$1.65

More than

$20

Let the put option expire

(don’t use it)

Cisco stock

price on 17

September, S

– ($19.26 + $2)=

- $21.26

In a spreadsheet, here’s the way this strategy looks:

Not so simple: How does this happen? Bullshit a bit about the exchange mechanism?????

PFE, Chapter 22: Introduction to options page 25

ABCDEFG

STOCK + PUT: OPTION STRATEGY PROFITS

Stock price, 7Aug01 19.26

Cost of put option 2

Put exercise price, X 20

Market price of Cisco.

21 September 2001

Exercise

the put

Profit/loss

on the put

Profit/loss

on the stock

Total

profit/loss

0 yes 18 -19.26 -1.26 <-- =C9+D9

5 yes 13 -14.26 -1.26

10 yes 8 -9.26 -1.26

16 yes 2 -3.26 -1.26

18 yes 0 -1.26 -1.26

20 no -2 0.74 -1.26

21 no -2 1.74 -0.26

22 no -2 2.74 0.74

25 no -2 5.74 3.74

28 no -2 8.74 6.74

30 no -2 10.74 8.74

32 no -2 12.74 10.74

34 no -2 14.74 12.74

Profit/Loss: Stock + Put

-25

-20

-15

-10

-5

0 5 10 15 20 25 30

Stock price, 21Sept01

Profit

Profit/loss

on the put

Profit/loss

on the stock

Total profit/loss

=IF(A9<$B$6,$B$6-A9,0)-$B$5

=A9-$B$4

Portfolio insurance strategies—which involve combinations of buying puts and shares

together—are popular strategies. They guarantee a minimum return on the investment in the

shares (at an extra cost, of course: you have to buy the puts).

PFE, Chapter 22: Introduction to options page 26

ANTICIPATING A BIT—put-call parity

You’ll notice that the graph of the stock+put strategy looks a lot like the graph of

a call (Section 2). This may lead you to surmise that the payoffs of the combination

stock+put is somehow equivalent to the payoffs of a call. However, this isn’t quite true,

as you’ll see in the next chapter. There we discuss the put-call parity theorem and show

that—for a put and call written on the same stock and having the same exercise price X:

(

)

tock put call PV X+=+

Stock + 2 puts

Suppose you purchased one share of stock and bought 2 puts, each costing $2 and each

having an exercise price of $20. Here’s what your payoff pattern would look like:

Stock price

on 17

September

Strategy Cash in hand,

17 September

Net profit

< $20 Exercise both put

options. Give someone

else your share of Cisco

for $20.

Buy an

additional share in the

market and give it to the

put writer for S

2*20 - S

– ($19.26 + $4)=

$16.74 - S

More than

$20

Let the put options

expire (don’t use them)

Cisco stock

price on 17

September, S

– ($19.26 + $4)=

- $21.26

If we make an Excel table, here’s what it looks like:

PFE, Chapter 22: Introduction to options page 27

ABCDEFG

STOCK + 2 PUTS PUT: OPTION STRATEGY PROFITS

Stock price, 7Aug01 19.26

Cost of put option 2.00

Put exercise price, X 20.00

Market price of Cisco.

21 September 2001

Exercise

the put

Profit/loss

on the puts

Profit/loss

on the stock

Total

profit/loss

0 yes 36 -19.26 16.74 <-- =C8+D8

5 yes 26 -14.26 11.74

10 yes 16 -9.26 6.74

16 yes 4 -3.26 0.74

18 yes 0 -1.26 -1.26

20 no -4 0.74 -3.26

21 no -4 1.74 -2.26

22 no -4 2.74 -1.26

25 no -4 5.74 1.74

28 no -4 8.74 4.74

30 no -4 10.74 6.74

32 no -4 12.74 8.74

34 no -4 14.74 10.74

Stock + 2 Puts

-5

0 5 10 15 20 25 30

Stock price, 21Sept01

Profit

=2*(IF(A8<$B$5,$B$5-A8,0)-$B$4)

=A8-$B$3

Comparing strategies

What’s better as a strategy: buying a share of Cisco and buying 1 put, or buying a share

of Cisco and buying 2 puts? A little thought will lead you to conclude that—in an efficient

market—this is not a sensible question; in an efficient market, where all assets and combinations

of assets are properly priced, there’s always a tradeoff between assets. Here’s a comparison of

the graphs:

PFE, Chapter 22: Introduction to options page 28

ABCDEFGH

STOCK + PUT COMPARED TO STOCK + 2 PUTS

Stock price, 7Aug01 19.26

Cost of put option 2.00

Put exercise price, X 20.00

Market price of Cisco.

21 September 2001 Stock + Put Stock + 2 Puts

0 -1.26 16.74 <-- =2*IF(A8<=$B$5,$B$5-A8,0)+A8-($B$3+2*$B$4)

5 -1.26 11.74

10 -1.26 6.74

16 -1.26 0.74

18 -1.26 -1.26

20 -1.26 -3.26

21 -0.26 -2.26

22 0.74 -1.26

25 3.74 1.74

28 6.74 4.74

30 8.74 6.74

32 10.74 8.74

34 12.74 10.74

Comparing Stock + Put to Stock + 2Puts

-5.00

0.00

5.00

10.00

15.00

20.00

0 5 10 15 20 25 30 35

Cisco price, 21Sept01

Profit

Stock + Put Stock + 2 Puts

=IF(A8<=$B$5,$B$5-A8,0)+A8-($B$3+$B$4)

The choice between the two strategies involves tradeoffs (that’s the nature of market

efficiency: in an efficient market no asset ever completely dominates another asset).

•

The stock+put strategy has higher profit when the Cisco September stock price > 20,

but it has a negative profit for Cisco S

< 20

•

The stock + 2 put strategy costs more (you can see this by noting that its payoff when

= 20 is less than that of the stock + put strategy). On the other hand, it has positive

profits both for very low and for high S

PFE, Chapter 22: Introduction to options page 29

Which strategy should you choose? It depends on your prediction of the future: If you

think that Cisco is going to make a big move, up or down, then stock + 2 puts is for you.

If you think, on the other hand, that Cisco might go up, but you want protection when and

if its price goes down (that is, no bets for you), then stock + put is your choice.

Stock + more puts

There’s almost nothing to say here, except to show you the graphs:

ABCDEFGHI

STOCK + SEVERAL PUTS PUT: OPTION STRATEGY PROFITS

Stock price, 7Aug01 19.26

Cost of put option 2

Put exercise price, X 20

Number of puts purchased 2

Market price of Cisco.

21 September 2001

Exercise

the put

Profit/loss

on single put

Profit/loss

on the stock

Total profit:

1 put

Total profit:

2 puts

Total profit:

3 puts

Total profit:

4 puts

0 yes 18 -19.26 -1.26 16.74 34.74 52.74

5 yes 13 -14.26 -1.26 11.74 24.74 37.74

10 yes 8 -9.26 -1.26 6.74 14.74 22.74

16 yes 2 -3.26 -1.26 0.74 2.74 4.74

18 yes 0 -1.26 -1.26 -1.26 -1.26 -1.26

20 no -2 0.74 -1.26 -3.26 -5.26 -7.26

21 no -2 1.74 -0.26 -2.26 -4.26 -6.26

22 no -2 2.74 0.74 -1.26 -3.26 -5.26

25 no -2 5.74 3.74 1.74 -0.26 -2.26

28 no -2 8.74 6.74 4.74 2.74 0.74

30 no -2 10.74 8.74 6.74 4.74 2.74

32 no -2 12.74 10.74 8.74 6.74 4.74

34 no -2 14.74 12.74 10.74 8.74 6.74

Total Profits: 1 Share of Stock + (1,2,3,4) Puts

-20

-10

0 5 10 15 20 25 30 35

Stock price, 21Sep01

Profit

Total profit:

1 put

Total profit:

2 puts

Total profit:

3 puts

Total profit:

4 puts

All the lines cross when stock price

= 18. At this point the net put profit

= 0 and the strategy produces a loss

of $2.