Short Selling vs. Put Options: An Overview

Short selling and put options are fundamentally bearish strategies used to invest on a possible decline within 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 in addition have differences that investors should understand.

Going Short the Market

Traders who use short selling essentially sell an asset they don’t hold of their portfolio. These investors do that in the idea that the underlying asset will decline in value in the longer term. This method also could also be generally known as selling short, shorting, and going short.

Traders and savvy investors who use put options also bet that the worth of an asset will decline in the longer term and state a price and timeframe wherein they are going to sell this asset.

For an experienced investor or trader, selecting between a brief sale and puts to implement a bearish strategy will depend on many aspects including investment knowledge, risk tolerance, money availability, and if the trade is for speculation or hedging.

Short Selling

Short selling is a bearish strategy that involves the sale of a security that will not be owned by the vendor but has been borrowed after which sold available in the market. A trader will undertake a brief sell in the event that they imagine a stock, commodity, currency, or other asset or class will take a big move downward in the longer term.

Because the long-term trend of the market is to maneuver upward, the means of short selling is viewed as being dangerous. Nonetheless, there are market conditions that experienced traders can reap the benefits of and switch right into a profit. Most frequently institutional investors will use shorting as a way to hedge—reduce the chance—of their portfolio.

Short sales will be used either for speculation or as an indirect way of hedging long exposure. For instance, if you will have a concentrated long position in large-cap technology stocks, you could possibly short the Nasdaq-100 exchange traded fund (ETF) as a solution to hedge your technology exposure.

The vendor now has a brief position in the safety—versus an extended position, where the investor owns the safety. If the stock declines as expected, the short seller will repurchase it at a lower cost available in the market and pocket the difference, which is the profit on the short sale.

Short selling is much riskier than buying puts. With short sales, the reward is potentially limited—since probably the most that the stock can decline to is zero—while the chance is theoretically unlimited—since 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 barely less risk when the safety shorted is an index or ETF because the risk of runaway gains in the whole index is far lower than for a person stock.

Short selling can be costlier than buying puts due to margin requirements. Margin trading uses borrowed money from the broker to finance buying an asset. Due to the risks involved, not all trading accounts are allowed to trade on margin. Your broker would require you will have the funds in your account to cover your shorts. As the value of the asset shorted climbs, the broker may also increase the worth of the margin the trader holds. 

Due to its many risks, short selling should only be utilized by sophisticated traders aware of the risks of shorting and the regulations involved. 

Put Options

Put options offer an alternate route of taking a bearish position on a security or index. When a trader buys a put option they’re buying the correct to sell the underlying asset at a price stated in the choice. There is no such thing as a obligation for the trader to buy the stock, commodity, or other assets the put secures.

The choice have to be exercised inside 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 won’t must buy the asset.

While there are some similarities between short selling and buying put options, they do have differing risk-reward profiles that will not make them suitable for novice investors. An understanding of their risks and advantages is crucial to learning concerning the scenarios where these two strategies can maximize profits. Put buying is significantly better fitted to the typical investor than short selling due to limited risk.

Put options will be used either for speculation or for hedging long exposure. Puts can directly hedge risk. For instance, say you were concerned a couple of possible decline within the technology sector, you could possibly buy puts on the technology stocks held in your portfolio.

Buying put options even have risks, but not as potentially harmful as shorts. With a put, probably the most which you could lose is the premium that you will have paid for getting the choice, while the potential profit is high.

Puts are particularly well fitted to hedging the chance of declines in a portfolio or stock because the worst that may occur is that the put premium—the value paid for the choice—is lost. This loss would come if the anticipated decline within the underlying asset price didn’t materialize. Nonetheless, even here, the rise within the stock or portfolio may offset part or all the put premium paid.

Also, a put buyer doesn’t should fund a margin account—although a put author has to provide margin—which suggests that one can initiate a put position even with a limited amount of capital. Nonetheless, since time will not be on the side of the put buyer, the chance here is that the investor may lose all the cash invested in buying puts if the trade doesn’t work out.

Implied volatility is a big consideration when buying options. Buying puts on extremely volatile stocks may require paying exorbitant premiums. Traders must be certain that the price of shopping for such protection is justified by the chance to the portfolio holding or long position.

Not All the time 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 will be used for bullish exposure as well.

For instance, say you’re bullish on the S&P 500. As a substitute of shopping for units of the S&P 500 ETF Trust (SPY), you initiate a brief sale of an ETF with a bearish bias on the index, resembling the inverse ProShares Short S&P 500 ETF (SH) that may move opposite to the index.

Nonetheless, if you will have a brief position on the bearish ETF, if the S&P 500 gains 1%, your short position should gain 1% as well. After all, specific risks are attached to short selling that may make a brief position on a bearish ETF a less-than-optimal solution to gain long exposure.

While puts are normally related to price declines, you could possibly establish a brief position in a put—generally known as “writing” a put—in the event you are neutral to bullish on a stock. Essentially the most common reasons to put in writing a put are to earn premium income and to amass the stock at an efficient price, lower than its current market price.

Here, let’s assume XYZ stock trades at $35. You are feeling this price is overvalued but can be fascinated by acquiring it for a buck or two lower. One solution to achieve this is to put in writing $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 doesn’t decline below $35, the put options expire worthlessly and the $1.50 premium represents your profit. Should the stock move below $35, it could be “assigned” to you—meaning you’re obligated to purchase it at $35, whatever the current trading price for the stock. Here, your effective stock is $33.50 ($35 – $1.50). For the sake of simplicity, we now have ignored trading commissions in this instance that you just would also pay on this strategy.

Short Sale vs. Put Options Example

For example the relative benefits and downsides of using short sales versus puts, let’s use Tesla Motors (TSLA) for example.

Tesla has loads of supporters who imagine the corporate could develop into the world’s most profitable maker of battery-powered automobiles. Nevertheless it also had no shortage of detractors who query whether the corporate’s market capitalization of over US$750 billion—as of February 2021—was justified.

Let’s assume for the sake of argument that the trader is bearish on Tesla and expects it to say no by December. Here’s how the short selling versus put buying alternatives stack up:

Sell Short on TSLA

• Assume 100 shares sold short at $780.00
• Margin required to be deposited (50% of total sale amount) = $39,000
• Maximum theoretical profit—assuming TSLA falls to $0—is $780 x 100 = $78,000
• Maximum theoretical loss = Unlimited

1. Scenario 1: Stock declines by $300 by December giving a possible $30,000 profit on the short position ($300 x 100 shares).
2. Scenario 2: Stock is unchanged at $780 in December, with $0 profit or loss.
3. Scenario 3: Stock rises to $1,000 by December, making a $22,000 loss ($220 x 100).

Buy Put Options on TSLA

• Assume buying one put contract (representing 100 shares) expiring in December with a 600 strike and a premium of $100.
• Margin required to be deposited = None
• Cost of put contract = $100 x 100 = $10,000
• Maximum theoretical profit—assuming TSLA falls to $0 is ($600 x 100) – $10,000 premium = $50,000)
• Maximum possible loss is the price of the put contract: $10,000

1. Scenario 1: Stock declines by $300 by December, there’s a $2,000 nominal gain in the choice because it expires with $120 intrinsic value from its strike price (600 – 480), value $12,000 in premium – but because the option cost $10,000, the online gain is $2,000.
2. Scenario 2: Stock is unchanged, the whole $10,000 is lost.
3. Scenario 3: Stock rises to $1,000 by December, the loss continues to be capped at $10,000.

With the short sale, the utmost possible profit of $78,000 would occur if the stock plummeted to zero. Alternatively, the utmost loss is potentially infinite if the stock only rises. With the put option, the utmost possible profit is $50,000 while the utmost loss is restricted to the value paid for the put.

Note that the above example doesn’t consider the price of borrowing the stock to short it, in addition to the interest payable on the margin account, each of which will be significant expenses. With the put option, there’s an up-front cost to buy the puts, but no other ongoing expenses.

Also, the put options have a finite time to expiry. The short sale will be held open so long as possible, provided the trader can put up more margin if the stock appreciates, and assuming that the short position will not be subject to buy-in due to large short interest.

Short selling and using puts are separate and distinct ways to implement bearish strategies. Each have benefits and downsides and will be effectively used for hedging or speculation in various scenarios.

Short Selling vs. Put Options FAQs

Can You Short Sell Options?

Short selling involves the sale of monetary instruments, including options, based on the idea that their price will decline.

Can I Short Sell Put Options?

A put option allows the contract holder the correct, but not the duty, to sell the underlying asset at a predetermined price by a particular time. This includes the flexibility to short-sell the put option as well.

What Is Long Put and Short Put With Examples?

An extended put involves buying a put option whenever you expect the underlying asset’s price to drop. This play is only speculative. For example, if Company A’s stock trades at $55, but you think the value will decline over the subsequent month, you possibly can generate income out of your speculation by buying a put option. This implies you are going long on a placed on Company A’s stock, while the vendor is alleged to be short on the put.

A short put, however, occurs whenever you write or sell a put option on an asset. To illustrate you think Company X’s stock, which trades at $98, will drop in the subsequent week to $90 and you select to make the acquisition. If the put option trades at $2, you sell it and net $200, setting at your buying price at $90, provided the stock trades at that price on or before the date of expiration.

What Is a Short Position in a Put Option?

A brief position in a put option is named writing a put. Traders who achieve this are generally neutral to bullish on a selected stock as a way to earn premium income. In addition they achieve this to buy an organization’s stock at a price lower than its current market price.