In the second part of the shorting options series, we look at two more ways of going short – options and inverse ETFs – and discuss the basic ways and professional tip of dealing with time and structural decay.

Adam Lass is on vacation this week. So today we’ll continue the discussion on “four ways to go short,” taking a look at options trading and inverse Exchange-Traded Funds (ETFs). If you missed it, catch up and read Four Ways to Go Short, Part I.

To be clear, there are a lot more than just four ways to go short (that is, to benefit from a price decline). But the topic of going short is so big and sprawling, it’s necessary to cut things down to a few basics at first, just to get a handle on it.

In Part I we talked about individual equities and ETFs, and mentioned some things to watch out for. In respect to options trading and inverse ETFs as shorting tools, there is one BIG thing you have to watch out for: Decay.

What are we talking about here? Not tooth decay, and not moral decay, but time and structural decay. More on that in a moment.

The Basics of Options: Puts and Calls

As you likely know, there are two basic types of options: puts and calls. A “put” gives you the right, but not the obligation, to sell at a specified price (the strike price). A “call” works in reverse fashion – it gives you the right, but again not the obligation, to buy at a specified strike price.

Here is a way to remember the difference: When bearish, you want to be able to “put” a bad stock onto someone else. So if you had bought five puts at a strike price of $25, and now the stock is trading for $15 after some bad news, you could “put” the obligation to buy 500 shares at $25 – ten bucks higher than the market is currently trading – onto some other guy.

Conversely, when bullish, you want to be able to “call away” a good stock after the price has gone up. So if you had purchased, say, calls on your favorite gold stock at a $10 strike price, and the stock subsequently jumped to $14 on a good earnings announcement, you could “call away” (i.e. exercise the right to buy) 100 shares per contract at that lower $10 price from some other trader.

Most of the time, options do not get “exercised” (the term for taking delivery of short or long shares). Instead, they are sold back to the market at their increased price. It is the option of exercising (no pun intended), plus a time premium and volatility component, that gives puts and calls their intrinsic worth.

Again, it can get more exotic and complicated than the above, but that’s the basic gist.

Options Melt Like Ice Cubes

In some ways, options are like miniature sticks of dynamite. They are a form of concentrated leverage, and give a lot of bang for the buck.

But in other ways, options are like ice cubes. Their value can melt away as the expiration date comes closer.

This is because, as mentioned above, a component of any option’s price is something called time premium. The longer that the option has until expiration, the more time premium is built into the price.

An option that is “out of the money” – one that has no intrinsic value yet because the strike price is out of range – has a price that is almost all time premium. On top of this, there is a volatility component. (The more volatile the instrument – i.e. the greater the odds it could move sharply up or down – the more costly the option will be.)

Dealing with Time Decay: Near or Far?

Time decay is a reality of purchasing options because someone has to get paid – in the form of a risk premium, as a function of time exposed – to have the incentive to take the other side of the trade. (Whenever someone buys an option in the hope of hedging a risk or making a profit, that option is sold, or “written,” by someone else.)

Again, when it comes to time decay from an option buyer’s perspective, there are strategies that range from the simple to the very complex. (Iron Butterfly, anyone?) But to keep it simple for today’s purposes, two straightforward ways to deal with time decay are by going “near” or “far” in terms of the calendar expiration date.

Going “near” means buying an option with only a few weeks, or maybe even just a few days, left to expiration. This is a highly aggressive approach, because the net result tends to be “all or nothing” – you either make a killing on the option, or you take the chance of letting it expire worthless.

The “near” strategy can work because, the closer an option gets to expiration, the faster the time premium drains out of it. This means there is less to pay for when you buy, and more leverage on the initial purchase price if the option moves in your favor. An option close to expiration is thus like a lit match. It doesn’t cost much, but it tends to burn down very quickly.

Buying an option close to expiration can be a profitable maneuver if you have very specific timing on a trade – where, say, you think a big move is likely to happen in the next three or four days if it is going to happen at all.

Rather than using a stop loss on such trades, the way to manage risk is to only put up what you can afford to lose. (Options are useful here in that, as long as you are a buyer of options – and not a seller – your risk is always limited to commissions and initial purchase cost.)

The other approach, when specific timing is less clear, is to go “far,” which means picking an expiration date for your option that allows plenty of time for events to develop in your favor.

This can mean buying options with an expiration date anywhere from a few months in the future to as far as one or two years down the road. Extra long-dated options are sometimes referred to as LEAPs or “Long-Term Equity Anticipation Securities.”

We’re only scratching the surface here. But these basics are important…

A New Tool: The Inverse Exchange-Traded Fund

Another tool that has gained popularity in recent years is the inverse ETF.

In a nutshell, inverse ETFs function as normal ETFs do – you can buy shares in them like a stock and hold them in a retirement account – except for one major difference. Inverse ETFs are designed to go upin price when the value of something goes down.

They are, more or less, a simple way to make a bearish bet. Here are a few examples, in no particular order, of popular inverse ETFs:

There are many, many more than the few inverse ETFs just listed. You can find an inverse ETF for just about every major industry, sector and commodity these days.

Most inverse ETFs are very liquid, trading in the millions of shares per day. And most of them can be purchased for an IRA or 401(k), which can be very helpful for certain accounts with restrictions on options buys or short sales.

Watch Out for Structural Decay

The thing to be careful of with inverse ETFs – and leveraged long ETFs too for that matter – is structural decay, also known as microstructure effects or microstructure decay.

The math is a little strange. But the bottom line is that the more leverage an inverse ETF has packed into it, the more likely the value of that ETF is to “decay” at a noticeable rate.

This doesn’t mean that inverse ETFs are invalidated as investing and trading tools. But it does mean they have a little bit more of an “option profile” than one might think.

Investors are used to thinking about options trading as time-wasting instruments because all plain vanilla options have fixed expiration dates. Inverse ETFs don’t have expiration dates – you can just purchase shares and sit on them – but they do have some of that time-wasting quality.

The way to deal with this is to be strategic in the timing of an inverse ETF purchase – just as you would with an option – and to be aware that reasonably prompt price movement is needed to offset this negative effect. You can’t throw these things in a drawer like a value stock.

Another alternative is to factor in a reasonable decay cost, not unlike a small insurance premium, if the inverse ETF is being purchased a hedge. Hedging is one of the most powerful uses of inverse ETFs. Say, for example, that you have a large percentage of your portfolio invested in crude oil and natural gas stocks, and you want to protect against downside risks without selling your stocks and triggering a capital gains penalty. One way to “hedge” would be purchasing a large block of shares in DUG, the Proshares Ultrashort Oil & Gas ETF (DUG), in such a manner that gains on DUG would offset a temporary price decline in your basket of crude oil and natural gas shares.

Pro Tip: Put Structural Decay in Your Favor

One final note: If you don’t have an aversion to shorting ETFs – that is to say, borrowing the shares and taking a direct short position – there is one way you can put structural decay effects in your favor.

The way to do this is to take outright short positions in bullish leveraged ETFs when feeling bearish. So, for example, if I were to take a bearish view on large-cap stocks, I might look at shorting BGU – the Large Cap Bull 3x shares ETF (BGU) – as opposed to going long BGZ (the more traditional inverse offering).

If this quick tip doesn’t make intuitive sense to you, don’t worry about it. It’s just a small way to take advantage of the fact that bullish leveraged ETFs suffer from structural decay effects to some degree too, which can act as a modest tailwind when positioned for ETF price decline.

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