Short selling vs. purchasing a put option: how do the payoffs differ?

Purchasing a put option and entering into a short sale transaction are the two most common ways for traders to profit when the price of an underlying asset decreases, but the payoffs are quite different. Even though both of these instruments appreciate in value when the price of the underlying asset decreases, the amount of loss and pain incurred by the holder of each position when the price of the underlying asset increases is drastically different.

A short sale transaction consists of borrowing shares from a broker and selling them on the market in the hope that the share price will decrease and you'll be able to buy them back at a lower price. (If you need a refresher on this subject, see our Short Selling Tutorial.) As you can see from the diagram below, a trader who has a short position in a stock will be severely affected by a large price increase because the losses become larger as the price of the underlying asset increases. The reason why the short seller sustains such large losses is that he/she does have to return the borrowed shares to the lender at some point, and when that happens, the short seller is obligated to buy the asset at the market price, which is currently higher than where the short seller initially sold.

In contrast, the purchase of a put option allows an investor to benefit from a decrease in the price of the underlying asset, while also limiting the amount of loss he/she may sustain. The purchaser of a put option will pay a premium to have the right, but not the obligation, to sell a specific number of shares at an agreed upon strike price. If the price rises dramatically, the purchaser of the put option can choose to do nothing and just lose the premium that he/she invested. This limited amount of loss is the factor that can be very appealing to novice traders. (To learn more, see our Options Basics Tutorial.)



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