Shorting in Tax Deferred Accounts

By Patrick King - January 14, 2012 | Tickers: BBRY, SHLD | 0 Comments

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The studious investor looks at a lot of stocks, a few of which he judges to be winners, most of which he is indifferent to or undecided about, and a few of which he judges to be losers. If there are really only a few investment ideas that you can believe in, can you afford to throw away half of them just because of the direction of movement?

Outright shorting of stocks (selling a stock you don't own) is a dangerous proposition, rightly prohibited in tax deferred accounts. Since there is no upper limit on a stock's price, there is no limit on a short position's potential losses. One mistake could devastate a retirement portfolio. So we need a vehicle that lets you profit from downward movement in a stock's price, but that poses a quantifiable risk.

One such vehicle is the put option. Consider Sears (NASDAQ: SHLD).  It announced last month that it was closing 120 stores after a disappointing holiday season. It has lost some of its ability to finance the purchase of new inventory. The only favorable number it has going for it is it's Price/Book ratio, which only really applies if Sears liquidates. All of these tidbits are remeniscint of K-Mart, which Sears bought (or was it the other way around? It can be hard to tell). It seems as if history is repeating itself.

Some see Sears' recent troubles as a buying opportunity. It might be. I haven't put any money down either way. But how would I play this situation?

As I write this, SHLD last traded at $36.75, down roughly 50% in the last 3 months. We want time for Sears to slide, and we don't want to pay too dearly for that time. At the close on 1/17, January 13 puts last traded at:

In general, more "in the money" puts require less of a time premium, and start to make money at a higher stock price. On the other hand, options further from the money tend to trade more thinly, and big price disparities are possible. Had I been trading yesterday, I'd have gone for the January 2013 $45 puts, which should start making money should SHLD fall below $32.90. If you don't think it unreasonable that SHLD should see $32.90 in 2012, then the $45 LEAPS could be a reasonable investment.

Research In Motion (NASDAQ: BBRY) (closing at $17.47 on Tuesday, 1/18) presents a different problem. RIMM has had a similar price slide. Its core business is probably in worse shape, with the reliability of its email service in question, its latest software delayed yet again, and its foray into tablets resulting only in a full warehouse. On the other hand, although supposed saviours deny interest, RIMM does have some intellectual property of value that could justify the recent price runup, so a straight short, or even a long put, may be too agressive.

How to play this? Exploit the negative sentiment by selling the time value we tried to avoid buying with SHLD! Yesterday, we could have the February $17 puts at $1.75, and bought the April $17 puts at $2.70, for a net investment of $0.95/share. As February expiration rolls around, we can expect the time value of the April contract to fall somewhat, but the February time value WILL be approaching zero. Assuming RIMM moves sideways, in February we can sell the April contract at around $2.20.

Of course, the possibility that RIMM doesn't move sideways is why we buy the far put in the first place. Should RIMM tank, and the buyer of the near put exercise it, we have the long put to cover it, just as one has stock to back oneself up when writing calls.

So, there's two possible ways to play downside sentiment while containing your risk. It's hardly "buy and hold", but who does that any more?

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