Short Selling vs. Put Options: An Overview
Short selling and put options are fundamentally bearish strategies used to speculate on a potential decline in the underlying security or index. These strategies also help to hedge downside risk in a portfolio or specific stock. These two investing methods have features in common but also have differences that investors should understand.
- Both short selling and buying put options are bearish strategies that become more profitable as the market drops.
- Short selling involves the sale of a security not owned by the seller but borrowed and then sold in the market, to be bought back later, with potential for large losses if the market moves up.
- Buying a put option gives the buyer the right to sell the underlying asset at a price stated in the option, with the maximum loss being the premium paid for the option.
- Both short sales and put options have risk-reward profiles that may not make them suitable for novice investors.
Going Short the Market
Traders who use short selling are, in essence, selling an asset they do not hold in their portfolio. These investors do this in the belief that the underlying asset will decline in value in the future. This method also may be known as selling short, shorting, and going short.
Traders and savvy investors using put options are also betting that the value of an asset will decline in the future and will state a price and a timeframe in which they will sell this asset.
For an experienced investor or trader, choosing between a short sale and puts to implement a bearish strategy depends on many factors including investment knowledge, risk tolerance, cash availability, and if the trade is for speculation or hedging.
Short selling is a bearish strategy that involves the sale of a security that is not owned by the seller but has been borrowed and then sold in the market. A trader will undertake a short sell if they believe a stock, commodity, currency, or other asset or class will take a significant move downward in the future.
Since the long-term trend of the market is to move upward, the process of short selling is viewed as being dangerous. However, there are market conditions that experienced traders can take advantage of and turn into a profit. Most often institutional investors will use shorting as a method to hedge—reduce the risk—in their portfolio.
Short sales can be used either for speculation or as an indirect way of hedging long exposure. For example, if you have a concentrated long position in large-cap technology stocks, you could short the Nasdaq-100 ETF as a way to hedge your technology exposure.
The seller now has a short position in the security—as opposed to a long position, where the investor owns the security. If the stock declines as expected, the short seller will repurchase it at a lower price in the market and pocket the difference, which is the profit on the short sale.
Short selling is far riskier than buying puts. With short sales, the reward is potentially limited—since the most that the stock can decline to is zero—while the risk is theoretically unlimited—because the stock's value can climb infinitely. Despite its risks, short selling is an appropriate strategy during broad bear markets, since stocks decline faster than they go up. Also, shorting carries slightly less risk when the security shorted is an index or ETF since the risk of runaway gains in the entire index is much lower than for an individual stock.
Short selling is also more expensive than buying puts because of the margin requirements. Margin trading uses borrowed money from the broker to finance buying an asset. Because of the risks involved, not all trading accounts are allowed to trade on margin. Your broker will require you have the funds in your account to cover your shorts. As the price of the asset shorted climbs, the broker will also increase the value of margin the trader holds.
Because of its many risks, short selling should only be used by sophisticated traders familiar with the risks of shorting and the regulations involved.
Put options offer an alternative route of taking a bearish position on a security or index. When a trader buys a put option they are buying the right to sell the underlying asset at a price stated in the option. There is no obligation for the trader to purchase the stock, commodity, or other assets the put secures.
The option must be exercised within the timeframe specified by the put contract. If the stock declines below the put strike price, the put value will appreciate. Conversely, if the stock stays above the strike price, the put will expire worthlessly, and the trader will not need to buy the asset.
While there are some similarities between short selling and buying put options, they do have differing risk-reward profiles that may not make them suitable for novice investors. An understanding of their risks and benefits is essential to learning about the scenarios where these two strategies can maximize profits. Put buying is much better suited for the average investor than short selling because of the limited risk.
Put options can be used either for speculation or for hedging long exposure. Puts can directly hedge risk. As an example, say you were concerned about a possible decline in the technology sector, you could buy puts on the technology stocks held in your portfolio.
Buying put options also have risks, but not as potentially harmful as shorts. With a put, the most that you can lose is the premium that you have paid for buying the option, while the potential profit is high.
Puts are particularly well suited for hedging the risk of declines in a portfolio or stock since the worst that can happen is that the put premium—the price paid for the option—is lost. This loss would come if the anticipated decline in the underlying asset price did not materialize. However, even here, the rise in the stock or portfolio may offset part or all of the put premium paid.
Also, a put buyer does not have to fund a margin account—although a put writer has to supply margin—which means that one can initiate a put position even with a limited amount of capital. However, since time is not on the side of the put buyer, the risk here is that the investor may lose all the money invested in buying puts if the trade does not work out.
Implied volatility is a significant consideration when buying options. Buying puts on extremely volatile stocks may require paying exorbitant premiums. Traders must make sure the cost of buying such protection is justified by the risk to the portfolio holding or long position.
Not Always Bearish
As noted earlier, short sales and puts are essentially bearish strategies. But, just as in mathematics the negative of a negative is a positive, short sales and puts can be used for bullish exposure as well.
For example, say you are bullish on the S&P 500. Instead of buying units of the S&P 500 exchange-traded fund (ETF) Trust (SPY), you initiate a short sale of an ETF with a bearish bias on the index, such as the inverse ProShares Short S&P 500 ETF (SH) that will move opposite to the index.
However, if you have a short position on the bearish ETF, if the S&P 500 gains 1%, your short position should gain 1% as well. Of course, specific risks are attached to short selling that would make a short position on a bearish ETF a less-than-optimal way to gain long exposure.
While puts are normally associated with price declines, you could establish a short position in a put—known as “writing” a put—if you are neutral to bullish on a stock. The most common reasons to write a put are to earn premium income and to acquire the stock at an effective price, lower than its current market price.
Here, let's assume XYZ stock is trading at $35. You feel this price is overvalued but would be interested in acquiring it for a buck or two lower. One way to do so is to write $35 puts on the stock that expire in two months and receive $1.50 per share in premium for writing the put.
If in two months, the stock does not decline below $35, the put options expire worthlessly and the $1.50 premium represents your profit. Should the stock move below $35, it would be “assigned” to you—meaning you are obligated to buy it at $35, regardless of the current trading price for the stock. Here, your effective stock is $33.50 ($35 - $1.50). For the sake of simplicity, we have ignored trading commissions in this example that you would also pay on this strategy.
Short Sale vs. Put Options Example
To illustrate the relative advantages and drawbacks of using short sale versus puts, let’s use Tesla Motors (TSLA) as an example.
Tesla has plenty of supporters who believe the company could become the world’s most profitable maker of battery-powered automobiles. But it also had no shortage of detractors who question whether the company’s market capitalization of over US$20 billion—as of Sept. 19, 2013—was justified.
Let’s assume for the sake of argument that the trader is bearish on Tesla and expects it to decline by March 2014. Here’s how the short selling versus put buying alternatives stack up:
Sell Short on TSLA
- Assume 100 shares sold short at $177.92
- Margin required to be deposited (50% of total sale amount) = $8,896
- Maximum theoretical profit—assuming TSLA falls to $0 is $177.92 x 100 = $17,792
- Maximum theoretical loss = Unlimited
- Scenario 1: Stock declines to $100 by March 2014 giving a potential $7,792 profit on the short position (177.92 – 100) x 100 = $7,792).
- Scenario 2: Stock is unchanged at $177.92 by March 2014 the short expire worthlessly giving $0 profit or loss.
- Scenario 3: C Stock rises to $225 by March 2014 – giving a potential $4,708 loss on short position (177.92 – 225) x 100 = negative $4,708).
Buy Put Options on TSLA
- Assume buying one put contract—representing 100 shares—at $29 with a strike at $175 expiring March 2014.
- Margin required to be deposited = None
- Cost of put contract = $29 x 100 = $2,900
- Maximum theoretical profit—assuming TSLA falls to $0 is ($175 x 100) - $2,900 = $14,600)
- Maximum possible loss is the cost of the put contract $2,900
- Scenario 1: Stock declines to $100 by March 2014 giving a $4,600 potential profit on the put position (175 – 100 = 75) x 100 = $7,500 - $2,900 contract = $4,600
- Scenario 2: Stock is unchanged at $177.92 by March 2014 giving a $2,900 loss of the contract price.
- Scenario 3: Stock rises to $225 by March 2014 giving a $2,900 potential loss on the put position as the put would not be picked up by another trader.
With the short sale, the maximum possible profit of $17,792 would occur if the stock plummeted to zero. On the other hand, the maximum loss is potentially infinite. The trader could have a loss of $12,208 at a stock price of $300, $22,208 if the stock rises to $400, and $32,208 at a price of $500, and so on.
With the put option, the maximum possible profit is $14,600, while the maximum loss is restricted to the price paid for the puts.
Note that the above example does not consider the cost of borrowing the stock to short it, as well as the interest payable on the margin account, both of which can be significant expenses. With the put option, there is an up-front cost to purchase the puts, but no other ongoing expenses.
Also, the put options have a finite time to expiry. The short sale can be held open as long as possible, provided the trader can put up more margin if the stock appreciates, and assuming that the short position is not subject to “buy-in” because of the large short interest.
Short selling and using puts are separate and distinct ways to implement bearish strategies. Both have advantages and drawbacks and can be effectively used for hedging or speculation in various scenarios.