Hi upscale,
I'll divide this answer into four parts. First, I'll address the
mechanics of shorting the stock. Second, I'll analyze the possible
results of this strategy. Third, I will describe some risks involved
with the strategy. Finally, since you asked for an opinion about
whether the strategy is a good idea, I will offer one.
Procedure
As you know, shorting the stock involves borrowing shares from a
stockbroker and selling them. So you get some cash and you have a
short position, which means that you owe the broker some shares.
To sell the stock short, you will need to have an account with a
broker. Since you will be borrowing from the brokerage, they will
want to be assured that you will be able to pay the loan back. They
are likely to require that you maintain a certain level of assets in
your account to provide this security, and if the stock goes up, they
may increase the level required.
At some point, you will want to cover your position, that is, pay back
the shares you have borrowed. If you cover your position by having
your broker buy the shares on the open market, this is simple: you
just give the broker an order. If you get the shares from the company
by exercising options, it is a little more complicated. I believe you
would need to get a stock certificate from the company and deliver the
certificate to the broker. At least, this is what I did when I
exercised options and sold the stock.
Analysis
You can indeed sell short to hedge against the stock going down. For
purposes of this analysis, I'll use a concrete example. Let's say you
have an option to buy one share for $10 in two years and the stock is
currently selling for $13 (using your specifications for the relation
between these prices).
If you do nothing, if the stock price is over $10 in two years, you
can exercise your option and make money. If the stock price is under
$10, you can do nothing and lose nothing.
If you sell one share short now, you get $13. In two years, if the
stock price is over $10, you can exercise your option and cover your
position, with a $3 profit you get now, not in two years. In effect,
you have locked in the gain on the difference between the current
price and the option price. If the stock is below $10, you can
refrain from exercising your option, cover your position by buying
stock on the open market, and gain $13 minus the stock price whenever
you sell.
Whether you short the stock or not, and whether it goes up or down,
you need never lose: you either break even or gain. And if you short
any number of shares, you are guaranteed a gain no matter what happens
to the stock price.
Risks
A guaranteed gain sounds pretty good, but there are some risks and
possible problems associated with this strategy.
First, it would be a good idea to check the stock option plan and
company policies and see if they say anything about selling the stock
short, as my colleague Omnivorous suggested. If the company has a
rule against it, it's probably not a good idea.
When you have a short position, if the company pays dividends, you
have to pay them. This could eat into your gains.
If the stock goes up, your broker may demand that you put up more
collateral. Stock options that have not yet vested are unlikely to be
acceptable as collateral, so you may have to come up with more assets
to keep in your brokerage account to maintain your short position
until your options mature. If you can't do that, the broker may
liquidate assets in your account and buy stock at a high price to
cover part or all of your short position. This would not be
desirable.
The broker can call back the shares you have borrowed and require that
you cover your position at any time. This is unusual, however.
Source:
http://www.fool.com/FoolFAQ/FoolFAQ0033.htm
A well-known risk of selling short is that your potential for gain is
limited, but your potential for loss is unlimited. Your options
protect you from loss, but if the stock goes up and you lose your
options, you could be in trouble. If you sold your share for $13 and
lost your option, and the stock went up to $20, you would lose $7 by
covering your position, with the potential to lose more if you waited
and the stock went up some more. You could lose your options if you
get fired, or if you choose to quit for a better opportunity. So in
the case where the stock price goes up, this would tend to discourage
you from quitting, which might be an undesirable constraint.
Finally, once you sell the stock short, you have a financial interest
in the stock price going down, which conflicts with your interest as a
conscientious employee in making the company succeed. The company is
giving you options because it wants to align your interest with the
company's interest, so that if the company succeeds, you make some
money. Selling the stock short undermines this strategy, and the
management would not be likely to approve if they knew about it.
However, you may consider yourself either sufficiently professional or
sufficiently powerless that you would not be swayed by the possibility
of making a killing by running your employer into the ground. Or you
may sell short a number of shares corresponding to only a fraction of
your options, so that on the whole, you still do better when the
company succeeds.
Opinion
The strategy sounds good in theory, and if you were certain that you
would have the options in two years, you were not employed by the
company, and the dividend rate was not too high, I would advise you to
go for it. But the conflict of interest angle weighs heavily with me,
and that consideration alone, even without the other problems I
described, would be sufficient for me to advise against this strategy.
The possibility of losing the options by losing the job and having to
cover the position at a high price also concerns me, but you are, of
course, in a better position than I to evaluate how likely that is.
I hope this information and analysis is helpful. If any of it is
unclear, or you would like more details, please ask for a
clarification.
--efn |
