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. 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 >>
  3. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
  4. 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 >>
  5. How is it possible to trade on a stock you don't own, as is done in short selling?

    Understand how the process of short selling allows a person to sell a stock he or she doesn't technically own by borrowing ... Read Answer >>
  6. 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 >>
Related Articles
  1. Trading

    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. Trading

    Difference Between Short Selling And Put Options

    Short selling and put options are used to speculate on a potential decline in a security or index or hedge downside risk in a portfolio or stock.
  3. Investing

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  4. Investing

    The Basics Of Short Selling

    Short sellers enable the markets to function smoothly by providing liquidity, and also serve as a restraining influence on investors’ over-exuberance.
  5. Investing

    Short Selling Risk Can Be Similar To Buying Long

    If more people understood short selling, it would invoke less fear, which could lead to a more balanced market.
  6. Trading

    Option Strategies For A Down Market

    All investors should be aware that the best time to buy stocks is when the market is tanking, according to history.
RELATED TERMS
  1. Short Sale

    A market transaction in which an investor sells borrowed securities ...
  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. Average Price Put

    A type of option where the payoff depends on the difference between ...
  5. Short Leg

    Any contract in an option spread in which an individual holds ...
  6. Short Selling

    Short selling is the sale of a security that is not owned by ...
Hot Definitions
  1. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  2. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  3. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  4. Indirect Tax

    A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An ...
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Beta

    Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. ...
Trading Center