A:

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.)

short_vs_put.gif
RELATED FAQS
  1. Can I make money using put options when prices are going up?

    It seems counterintuitive that you would be able to profit from an increase in the price of an underlying asset by using ... Read Answer >>
  2. Are put options more difficult to trade than call options?

    Learn about the difficulty of trading both call and put options. Explore how put options earn profits with underlying assets ... Read Answer >>
  3. When does one sell a put option, and when does one sell a call option?

    The incorporation of options into all types of investment strategies has quickly grown in popularity among individual investors. ... Read Answer >>
  4. How do speculators profit from options?

    As a quick summary, options are financial derivatives that give their holders the right to buy or sell a specific asset by ... Read Answer >>
  5. What risks should I consider taking a short put position?

    Learn what risks to consider before taking a short put position. Shorting puts is a great strategy to earn income in certain ... Read Answer >>
  6. Is it more advantageous to purchase a call or put option?

    Learn the advantages of put and call options to choose the right side of the contract to meet your personal investment objectives. Read Answer >>
Related Articles
  1. Trading Strategies

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  2. Options & Futures

    Options Pricing: Factors That Influence Option Price

    There are six primary factors that influence option prices, as shown in Figure 2 and discussed below. Figure 2: Six factors that affect option prices ...
  3. Professionals

    Options: Calls and Puts

    CFA Level 1 - Options: Calls and Puts. Learn the two main types of option derivatives and how each benefits its holder. Provides an example multiple choice question for an option.
  4. Options & Futures

    Options Basics: Conclusion

    Options are sophisticated trading tools that can be dangerous if you don't educate yourself before using them. Please use this tutorial as it was intended - as a starting point to learning ...
  5. Options & Futures

    Options Basics: What Are Options?

    An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock ...
  6. Options Seller Traders

    In contrast to buying options, an options seller trader sells stock options. This comes with an obligation to sell the underlying equity to a buyer if that buyer decides to exercise the option ...
  7. Professionals

    Calls And Puts

    Calls And Puts
  8. Options & Futures

    Bear Put Spreads: A Roaring Alternative To Short Selling

    This strategy allows you to stop chasing losses when you're feeling bearish.
  9. Options & Futures

    Prices Plunging? Buy A Put!

    You can make money on a falling stock. Find out how going long on a put can lead to profits.
  10. Options & Futures

    20 Investments: Options (Stocks)

    What Is It? Options are a privilege sold by one party to another that offers the buyer the right to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time ...
RELATED TERMS
  1. Average Price Put

    A type of option where the payoff depends on the difference between ...
  2. Short Put

    A type of strategy regarding a put option, which is a contract ...
  3. Backspread

    A type of options spread in which a trader holds more long positions ...
  4. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  5. Put On A Call

    One of the four types of compound options, this is a "put" option ...
  6. Put On A Put

    One of the four types of compound options, this is a put option ...

You May Also Like

Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center