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. 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 >>
  2. 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 without technically owning it. Read Answer >>
  3. How does one make money short selling?

    Short sellers make money by betting a stock they sell will drop in price. If it drops, the short seller buys it back at a ... Read Answer >>
  4. How does short selling help the market and investors?

    Find out how short sellers provide a service to the market by acting as a check against overvalued companies and exposing ... Read Answer >>
  5. Is short selling a form of insurance?

    Explore short selling and put options. Learn how put options may be used as insurance to protect positions, and costs associated ... 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. Trading

    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.
  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

    Short Interest: What It Tells Us

    Whether you agree with the overall sentiment or not, short interest is a data point worth adding to you overall analysis of a stock.
  7. Investing

    What are Options Contracts?

    An explanation of options contracts, call options and put options.
RELATED TERMS
  1. Short Sale

    A short sale involves borrowing shares in anticipation of a price ...
  2. Short Put

    A type of strategy regarding a put option, which is a contract ...
  3. Average Price Put

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

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

    Short selling is the sale of a security that is not owned by ...
  6. Net Short

    Net short is a portfolio or trading position where an investor ...
Hot Definitions
  1. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability ...
  2. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  3. Whole Life Insurance Policy

    A life insurance contract with level premiums that has both an insurance and an investment component. The insurance component ...
  4. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  5. Capital Asset Pricing Model - CAPM

    A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. ...
  6. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability of potential investments.
Trading Center