Trading Tactics for the Short Side

by Michael Shulman

There are a few trading tactics you should familiarize yourself with before going short with put options.

* Timing: More so than with a long position, time is money. So unlike with typical long positions, it's imperative that you set time horizons for short-side investments and try to stick with them. I know I am repeating myself, but I consider this so important that it is worth the double entry: Make sure to set up an investment horizon for each short position.

* Edging In: Technical movements in stocks are much more important on the short side than for a longer-term investor. If a stock is bouncing around, you can edge into your put-option positions with small purchases within a price range, not at one fixed price. For example, if a Merck (MRK) put for a certain date is $4, but for the past few days it has traded between $3.80 and $4.20, be patient. Nibble and get some at $4, but also put in bids for $3.90 and $3.80 and see what happens.

* Rolling a Position: This is a critical tactic for managing a successful position to maximize profit and minimize risk. Let's say you did buy those Dell $40 put options and they went from $3.50 to $12.50 -- but you think the stock is going to sink even more. You would sell the puts for $12.50, pocket the profits for another investment or trade, take your initial investment and reinvest it in a call at the $30 strike price with the same or a later exercise date.

This is called rolling a position -- and one reason to do this is to manage a position that is not working. It serves to minimize risk by periodically pulling profits off the table without abandoning the position entirely. You can also use rolling to ride a stock that is on a continuous slide, whereby you are stopping to take profits along the way and initiating newer positions that give you greater leverage.

* Hedging: Some people get silly and end up with too much money on the short side. If you find yourself in that position (and I hope you do not!), you should hedge your exposure against a big market upswing through the purchase of call options on the S&P 500 -- just enough to protect your short positions against unforeseen circumstances, like the president of Iran going back to Mars or the Federal Open Market Committee cutting interest rates by 200 basis points.