Monday, August 24, 2009

Put Option Short Position

I wanted to share with a Twitter friend a strategy he said was too sophisticated for him. I mentioned that I purchased a put option on the $TNA. It is an 3x inverse ETF. I chose to go with the short side instead of going long his cousin the $TZA because I've noticed that these ETFs seem to have a propensity to go down faster than they go up. Look at FAS and FAZ (when one goes up the other is suppose to go down), both of them are lower today than they were when they came public. It have something to do with a tracking error, but that's a whole other story. Well, for about a dollar a contract, I was able to buy a put on the $TNA with a strike price of $41. Since the TNA closed under $41 a share, when it exercised my broker sold 100 shares of TNA at $41/share. But there is a problem.... I don't own TNA, so my broker goes out and borrows 100 shares from somebody with a margin account and give them to me so I can sell them! Now I'm short TNA. Here were my risks:
  1. If TNA were to close above $41 a share on Friday, my losses would have been limited to the premium I paid for TNA
  2. If TNA were to close below $41 a share on Friday, I get my exercise and short the stock. Then last weekend, let's say news comes out which causes the market to rally hard, I would end up in bad shape because TNA would have opened much higher, but I would be sitting in a short position. (this is the real risk, it happened a few months ago when I tried something similar with Bank of America, luckily I had an offsetting position in Citibank which saved me)
Here is something interesting that I just had to find out for myself. Since you cannot short stocks in an IRA account, what happens if our put option expires in the money and you don't own the stock? You still get the sale and depending on your broker, he gives you a chance to buy it back in 3 days T-3 rule (E*Trades style) OR they auto execute a buy order to settle your account (Fidelity's style) and you take a 90 day free riding trading restriction.

Now for my history lesson:
Years ago, my friend and I were trading stocks with a hot shot stock broker in town. He was all into the high octane stocks. Trade after trade, we were making money (didn't have the good sense to realize we were in the midst of a market rally and everything was going up). Then one day, our broker told us we could make 10 times the money we were making with options. To this day, I'm not sure if I curse that day or not! Our eyes got big and instead of doing the same research we did before we got into stock investing, we took the 30 minute short course and dove into the deep end and we got burned bad. Really bad. I swore off options for years. Before you get into options realize this:

With stocks time works with you. With options time works against you. With options, you can lose your shirt with no rags left, with stocks at least you have the rags!
Our problem was not that we chose the wrong stocks, our timing was off.

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