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Let's say I have done research and have a view that a public company's stock will go down due to worsening fundamentals. So normally then, one can express that view by shorting the stock. However, there's a risk that the company could get bought out and could gap up 40% overnight.

Is there a way for me to buy a relatively inexpensive hedge that would only pay me if the stock jumps up very rapidly (e.g. due to an acquisition), and wouldn't pay me if the stock goes up gradually? I'm wondering if there's some options strategy that can do that.

If there is, then I could potentially then use that options strategy to hedge the short position. Does such a thing exist or can it be constructed somehow?

I'm aware I could buy an out of the money call option as a hedge, but that's going to be more expensive since it would pay me even if the stock goes up slowly, and I'm only trying to hedge against the scenario that the stock jumps up a lot very quickly due to an acquisition.

Thanks

  • In theory you should buy an option that is out-of-the-money at the price you think the stock will jump to, and expires in a short time (so it will only be usable if the price jumps up suddenly, but will expire if it rises gradually). In practice there may not be such an option available for every stock. – BrenBarn Feb 2 '16 at 17:10
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Firstly, going short on a stock and worrying if the price suddenly gaps up a lot due to good news is the same as being long on a stock and worrying that the price will suddenly collapse due to bad news.

Secondly, an out of the money call option would be cheaper than an in the money call option, in fact the further out of the money the cheaper the premium will be, all other things being equal.

So a good risk management strategy would be to set your stop orders as per your trading plan and if you wish to have added protection in case of a large gap is to buy a far out of the money call option. The premium should not be too expensive. Something you should also consider is the time until expiry for the option, if your time frame for trading is days to weeks you make consider a cheaper option that expires in about a month, but if you are planning on holding the position for more than a month you might need a longer expiry period on the option, which will increase the premium.

Another option to consider, if your broker offers it, is to use a guaranteed stop loss order. You will pay a little premium for this type of order and not all brokers offer it, but if it is offered you will be protected against any price gaps past your guaranteed stop loss price.

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    Your first paragraph is not really correct, as a short position has unlimited downside, whereas with a long position you can't lose more than you initially invested. – BrenBarn Feb 2 '16 at 4:17
  • In theory, but unless you are shorting a volatile penny stock where a 10c inrease represents a 200% to 300% increase, then in reality both situations would be similar. – Victor Feb 2 '16 at 4:58
  • Plus the OP is talking about a 40% move, which would definately be possible going long or short. – Victor Feb 2 '16 at 5:01
  • Are there any brokers that offer guaranteed stop loss on individual stocks? Which? Interactive brokers seems to do everything but I don't see that option on their site unless I just missed it. – Tarak Feb 2 '16 at 15:53
  • @Tarak - my broker in Australia offers it for some instruments, I don't know what country you are in so can't comment on that. – Victor Feb 2 '16 at 18:59
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For a cheaper hedge , you can try a call spread.

e.g if you shorted a stock at 40 but are worried that it can get bought out for 60. then buy a 50-60 bull call spread with appropriate number of contracts or even 50-55. this is better than just buying a 50 call as it will be expensive.

Also the other option is not to short but buy a debit bear put spread 40-30 near the money and then buy an out of money call spread ( 55-60).

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