If you call your broker requesting to short a stock or an exchange-traded fund (ETF) in a registered account (e.g. RRSP or TFSA account), your broker will reply that the tax regulation does not allow such transactions in registered accounts. In fact, short selling is only available in margin accounts.
For those who are not familiar with the concept of short selling, it is a strategy used to achieve returns when you anticipate that the share price will tumble. Your broker lends you the shares (that you do not own) so that you can sell them on the market. If the share price falls, you can buy them back (at a lower price) and return them to your broker. Ultimately, you have managed to SELL high and BUY lower. However, short selling has its own set of risks. First, if the stock price spikes up, you will be in a losing position because it will now cost you more to buy back the shares to close your short position. Second, your broker can issue a notice to buyback the shares before the market closes. This is called a short squeeze or buy-in. You need to comply with the buy-in when you receive your broker’s notice, regardless of whether your short sell is in a loss or not. Third, as a short seller, you are responsible for the dividends paid. If during the period that you short the stock, it pays a dividend, your account will be debited of the dividend amount. With full knowledge of these facts, it is pretty difficult to justify short selling.
But there is a solution. Not only can you profit from a falling share price, but you can do this within a registered account with limited risk. In the sophisticated world of options, there are put options. By buying a put option, you are essentially locking in a selling price (strike price). The value of a put option will increase if the price of the underlying stock drops.
For example, Mike and Julie both strongly believe that ABC’s price will drop in the coming months. Mike shorts the stock at $33.50 and Julie buys a $35 put option on ABC stock for $2.75 (therefore $275 per contract of 100 underlying shares). Each put option is equivalent to shorting 100 shares.
Note that for simplicity, the financing cost of short selling is not considered (please consult your broker for more details).
|Date and Operation||Price of ABC Stock
Michael sells 100 ABC shares short
Julie buys 1 $35 put option on ABC shares for $2.75
($2.75 x 100)
($33.50 x 100)
Michael buys back 100 ABC shares
Julie sells 1 $35 put option on ABC shares for $7.75
($7.50 x 100)
(-$28.50 x 100)
|Return on invested capital
In terms of return, the main difference between Julie’s and Mike’s trades is the amount invested or the leverage in options. The investment with Julie’s put option position corresponds to the premium paid, whereas Mike’s short sell requires maintenance of a minimum margin in his account. By using a put option, Julie has limited and pre-defined the risk compared to Mike’s actual use of the underlying stock.
Now, what if the price of ABC stock had risen instead? Mike would have incurred losses on his short stock position. Julie’s option position, on the other hand, could not have cost her more than the $275 premium originally paid. This limited risk feature is very valuable to investors who are unable to withstand potentially large losses. Unlike short sellers of stocks, put buyers pay the contract premium and have no further financial obligation. Do not worry, buying put options for a bearish view is fully legitimate in a registered account. Until next time, may the best trades be with you.
By Richard Ho, CAIA, DMS, FCSI
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