In this article I will explain how short sales of stock and selling

(writing) listed calls are carried out. 

Apple Example Stock $140:

Assume that you are bearish on Apple computer and

tell your broker to short sell 1000 deltas (equivalent share

position) of the stock.

He may ask you if want to write calls , short stock or buy puts.

Short sale of stock:

Suppose you tell him to short the stock.

This is exactly what should happen: The broker finds

an owner of the 1000 shares who agrees to allow

his stock to be lent to you for short sale purposes. This is

what has already happened in most cases whenever

the stock is held by the broker in a margin account

for the owner.

The broker borrows the stock on your behalf and

sells it in the market at perhaps 140 to a buyer.

The $140,000 proceeds of the sale are deposited into

an account held by the broker where the broker earns

interest. In some rare cases, the broker is willing to

share the interest earned with the customer selling short.

The customer is required to deposit cash equal to 50%

of the value of the stock or marginable securities that

can be deposited as a substitute for the cash.

This cash or securities are placed in your margin

account. You should earn interest on the cash

sitting in your margin account. You could buy

Treasury Securities with the deposited margin cash if you

wished.

If the stock goes to 100, then $40,000 is transferred

into your margin account from the account to which

it was originally deposited as a result of the short sale.

You can take out that $40,000 with no tax, no

borrowing and no interest.

Also your initial margin requirements have been

reduced to 50% of $100,000.

If the stock goes lower, perhaps to 60, there will be

a similar transfer as above. Essentially the short

seller gets to keep the gain without a tax or borrowing.

If the position is covered there will be a tax on the

profit.

Of course if the stock goes up after the short sale

is made, there are transfers of money in the opposite

direction and the maintenance margin requirement goes up.

If the short position is covered at a loss, then there

is a taxable event (a loss) upon the cover.

Selling Calls

When selling (writing) calls, there is no borrowing

stock. There is merely a contract between the seller

(writer) and the Options Clearing Corporation. The

buyer also has a contract with the Options Clearing

Corporation. The premium that the buyer pays

to the OCC is then passed on to the writer.

That premium is immediately deposited into your margin

account not the broker's account as in the short sale.

The proceeds from the call "writes" should earn interest

for the writer. Cash or securities are required to be

deposited to initiate and hold the written call position.

The margin requirements change as the underlying stock

changes in value.

So the seller of calls has an advantage over the short

seller of stock due to the procedure as to how the

proceeds of the sale are deposited. The margin

requirements for call selling is much lower than for short

selling stock.

Margin deficits are the result of up moves and margin

credits are a result of down moves.

Selling calls is also different from shorting stock in the

sense that the gain on the calls sold is limited to the

value received regardless of how much the stock drops.

In the case with calls sold, a taxable event occurs when

the calls are out of the money at expiration day.

Whereas the tax gain on the successfully shorted stock

can be delayed forever.

Short selling stock or options allows the hedging of

ESO risks and to efficiently enhance the after tax

results to holders of ESOs. However, the selling of calls to

hedge ESOs is by far the preferred way, in my view.

Buying Puts:

Sometimes buying puts is the preferred way to hedge.

Here you pay the value of the puts from your account to

the OCC and the proceeds go to the seller of the puts.

This is the case when the hedger wants to avoid all

further deposits from possible margin calls or he may

want to do his hedging inside a IRA.

Buying puts also offers more protection from extreme

moves on the downside and allows more upside potential

gain on the combined positions of long puts and long ESOs.

There is a cost to those advantages in that

there is erosion of the time premium which may result

in the stock moving somewhat lower and the puts not

increasing. Generally out of the money puts are

the most overpriced listed options that are traded. So

if those are bought then there is another extra cost.

One additional advantage to buying puts is that if a

person buys long term puts and makes a profit, he

may will able to achieve long term capital treatment

if he hold the options position for over one year,

which he can not do if the sells calls.

John