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https://finance.zacks.com/high-short-interest-ratio-potential-sizable-short-squeeze-3371.html claims you can hedge against being squeezed out of your short position by buying call options with a strike price slightly above the current spot price. But AFAIK most option sellers would buy the underlying security when selling a call option (i.e. sell a covered call), to protect against the unlimited downside risk of an uncovered call option. That would mean that the supposed hedge against the short squeeze actually supports that short squeeze. It would be like covering your short position indirectly - not buying the underlying security directly, but causing someone else to buy it. I know that you could set the strike price much higher than the current spot price, but that would not be a very good hedge. What am I missing? Is Zacks just wrong?

Edit: Given the feedback, the strategy still does not make much sense to me. If the short percentage is high (let's say 50% of the float) and therefore the risk of a short squeeze real, my option dealer should have mostly calls on his book (because investors betting against the underlying would likely short it directly instead of buying puts, everyone else will want calls). So if I buy a call to protect me, my dealer would have to delta hedge by, say, 0.4 shares for every call I buy. But at a short percentage of 50%, that should move the price as much as if someone had bought maybe 0.8 shares (only a rough estimate) in a market with short percentage 0. So I may not cause someone else to buy 1 share, but 0.8 shares, which still increases the probability of being squeezed a lot. I can only prevent that by buying a call with a really low delta, i.e. a really high strike price, which would cause me tremendous losses before my protection kicks in if a short squeeze really happens.

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Yes one could hedge a short position from getting squeezed by buying a call. This is equivalent to being long a naked put. This is preferred over the "stop buy order" if you want to be certain of the price that you will be covering your short in the event of a squeeze. A "stop buy order" becomes a market order when the stock hits the stop level and there is no guarantee on the price where one will be filled. However, the guarantee of the fill price to cover the short will come at the cost of the call premium (or the put premium if one just buys a put instead).

The dealer selling you the calls will delta hedge their position and not sell the full covered call (unless they are also buying your short stock position, in which case they would likely be overhedged on their option and would then have to sell part of the position they are buying from you). For example, if the call they are selling you is at-the-money, this delta will be about 0.5 and they will only buy 0.5 a share for each call they sell you. Also, they are hedging delta on a book of options and not necessarily on each and every option individually. At the extreme, they have another client on the line that wants to sell calls outright. If the number, strike and maturity lines up with the calls you are buying, they will already have the full hedge and not have to hedge the delta at all (they just collect the bid-ask spd). Of course this rarely happens instantaneously and they will hedge the net delta of the book (as well as other greeks/exposure they don't want).

As for your point re: your hedge working against the risk you are trying to hedge, this is always the case. The ultimate counterparty to your hedge is always taking the opposite position on the risk you are trying to hedge.

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  • $\begingroup$ Can I just buy naked call options whenever I like? I would expect every reasonable counterparty to only sell me covered calls, not naked calls. $\endgroup$ Commented Feb 18 at 14:24
  • $\begingroup$ @user2845840 Edited my answer to address your comment. $\endgroup$
    – AlRacoon
    Commented Feb 18 at 18:01

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