Barnes & Noble: How To Hedge A Short Sale (NYSE: BKS)


News hit the tape that MSFT will invest $300 MM into BKS to support the NOOK. While we are 1 hour from the 9:30 am ET open, BKS is up 92% on the news, which has obviously caught everyone off guard.

The short sellers are getting murdered as they are buying frantically along with the new longs and existing longs who want to add to their positions. Short selling involves borrowing BKS shares, selling them, and purchasing them back at a lower price. In that instance the trader keeps the difference and returns the shares to the lender.

That’s when things work out. When stocks rise against the short seller, s/he loses money. And since their is no upper boundary to the shares’ price, the risk is said to be unlimited.

To hedge against this risk while short, a trader can purchase call options above the market price to capture any violent reactions to the upside, such as the one we see this morning. This is the best option, literally and figuratively, to offset the risk to the upside.

Selling put options against a short sale is technically considered a “covered” position, but the trader only gets to keep the option premium. If the stock drops far enough, the put option will be exercised and the short seller will be forced to repurchase the stock thereby covering the short position. The option seller keeps the premium also.

But that typically amounts to a few dollars which the put seller will get to keep. However, against a $13 rise, keeping $3 in option premium is the proverbial set of steak knives.

Most traders are taught rightfully to place protected buy stops above the market to purchase the shares and offset the short sales. In instances such as today, there is oftentimes no liquidity since the whole world seemingly wants to buy the stock. Stop orders become market orders once the shares trade “at or through” the stop price that the trader delineates on the order ticket.

If I’m short at $15 and I’ve placed my protective Buy Stop at $18, once BKS trades at $18 or higher, I will get filled at the market. That could be significantly higher. The first trade might not go off until $22. That is “at or through” $18, so there will be significant “skid” or slippage as it’s called on my order. Slippage and skid is an expense to the trader.

A trader could have purchased a call with a $15 Strike Price so that all of today’s news would have been captured in the option premium, thereby benefiting and hedging the short seller for any damage above $15.

The only way to capture that $4 slippage is by owning call options to hedge your short position (especially over weekends). Owning options is a pure hedge. Selling options is a partial hedge strategy and is typically used as a strategy to generate more income.


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