Short Selling vs. Put Options: An Overview
Short selling and put options are fundamentally negative methods used to bet on the underlying securities or index’s possible fall. These tactics may also assist to mitigate downside risk in a portfolio or individual stock. These two investment approaches have similarities but also distinctions that investors should be aware of.
- Short selling and purchasing put options are both bearish techniques that increase in profitability when the market falls.
- Short selling is selling a security that the seller does not own but borrows and then sells in the market, with the possibility for substantial losses if the market rises.
- Purchasing a put option gives the buyer the right to sell the underlying asset at the price specified in the option, with the maximum loss being the option premium paid.
- Short sells and put options both have risk-reward profiles that may not be suited for inexperienced investors.
Going Short the Market
Traders that utilize short selling effectively sell an asset that they do not own. These investors do so on the expectation that the underlying asset would lose value in the future. This strategy is also known as selling short, shorting, and going short.
Put options are used by traders and astute investors to wager on the future value of an asset and to specify a price and timeframe for selling that asset.
Choosing between a short sale and options to execute a bearish strategy relies on a variety of criteria, including financial expertise, risk tolerance, cash availability, and if the transaction is for speculation or hedging.
Short selling is a bearish approach that includes selling a securities that the seller does not own but has borrowed and then sold in the market. A trader will engage in a short sale if they anticipate that a stock, commodity, currency, or other asset or class will see a major decline in the future.
Because the market’s long-term tendency is upward, the technique of short selling is seen as risky. However, there are market situations that skilled traders may exploit and benefit from. Most institutional investors will utilize shorting to hedge (lower risk) in their portfolio.
Short sales may be used for speculative purposes or as an indirect method of hedging long exposure. For example, if you had a concentrated long position in large-cap technology equities, you may hedge your technology exposure by shorting the Nasdaq-100 exchange traded fund (ETF).
The seller now owns the security in a short position, as opposed to a long position, in which the investor owns the security. If the stock falls as projected, the short seller will repurchase it at a lower market price and pocket the difference, which is the short sale profit.
Short selling is significantly more dangerous than purchasing puts. Short sells have a potentially restricted return since the stock’s maximum decrease is zero, but the risk is theoretically limitless because the stock’s value may rise indefinitely. Short selling is an acceptable technique during broad bear markets, despite its hazards, since equities decrease faster than they rise. Also, shorting an index or ETF involves significantly less risk since the chance of runaway gains in the whole index is considerably smaller than for an individual stock.
Because of the margin requirements, short selling is also more costly than purchasing puts. Margin trading involves borrowing money from a broker to fund the purchase of an item. Because of the inherent dangers, not all trading accounts are permitted to trade on margin. Your broker will demand that you have sufficient cash in any account to cover your short positions. The broker will boost the value of the trader’s margin as the price of the asset shorted rises.
Short selling should only be employed by knowledgeable traders who are aware with the hazards of shorting as well as the rules involved.
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Put options provide another way to take a negative position on a securities or index. When a trader purchases a put option, he or she is purchasing the right to sell the underlying asset at the price specified in the option. The trader is under no obligation to acquire the stock, commodity, or other assets that the put secures.
The put contract requires that the option be executed within the term provided. If the stock falls below the put strike price, the put value rises. If the stock remains above the strike price, the put will expire worthless, and the trader will not need to purchase the asset.
While short selling and purchasing put options have certain similarities, they have different risk-reward profiles that may not be ideal for beginner investors. Understanding the risks and advantages of these two techniques is critical to knowing about the circumstances in which these two tactics might optimize profitability. Because of the lower risk, put purchasing is a better option for the ordinary investor than short selling.
Put options may be used to speculate or to hedge long exposure. Puts may be used to directly hedge risk. If you were worried about a prospective collapse in the technology sector, for example, you might purchase puts on the technology companies in your portfolio.
Purchasing put options has risks, although they are not as dangerous as shorting. With a put, the most you can lose is the premium you paid for the option, but the potential reward is enormous.
Puts are especially well suited for hedging the risk of a portfolio or stock fall since the worst that can happen is that the put premium—the amount paid for the option—is lost. This loss would occur if the predicted drop in the underlying asset price did not occur. Even in this case, the increase in the stock or portfolio may negate some or all of the put premium paid.
Furthermore, unlike a put writer, a put buyer does not need to finance a margin account, which implies that a put position may be started with a little amount of cash. However, since time is not on the put buyer’s side, the danger is that the investor will lose all of the money invested in purchasing puts if the deal does not work out.
When purchasing options, implied volatility is an important factor to consider. Purchasing puts on highly volatile equities may necessitate paying expensive premiums. Traders must ensure that the expense of purchasing such protection outweighs the danger to the portfolio holding or long position.
Not Always Bearish
As previously stated, short sells and puts are fundamentally negative tactics. However, much as the negative of a negative is a positive in mathematics, short sales and puts may also be employed for bullish exposure.
Assume you are optimistic on the S&P 500. Instead of purchasing S&P 500 ETF Trust (SPY) units, you commence a short sale of an ETF with a negative bias on the index, such as the inverse ProShares Short S&P 500 ETF (SH), which will move in the opposite direction of the index.
If you hold a short position in the bearish ETF, if the S&P 500 rises by 1%, your short position should rise by 1% as well. Of course, there are dangers associated with short selling, making a short position on a bearish ETF a less-than-ideal approach to get long exposure.
While options are often connected with price falls, if you are neutral to positive on a company, you might construct a short position in a put (known as “writing” a put). The most popular motives for writing a put are to receive a premium income and to purchase the shares at a lower effective price than the current market price.
Assume XYZ stock is trading at $35. You believe this price is excessive and would like to get it for a buck or two less. One method is to write $35 puts on the stock that expire in two months and collect a premium of $1.50 per share for doing so.
If the price does not go below $35 in two months, the put options expire worthless, and the $1.50 premium represents your profit. If the stock falls below $35, it is “assigned” to you, which means you are compelled to purchase it at $35 regardless of the company’s current trading price. Your effective stock in this case is $33.50 ($35 – $1.50). To keep things simple, we’ve left out the trading fees that you’d have to pay if you used this approach.
Short Sale vs. Put Options Example
To demonstrate the relative benefits and downsides of employing short sells against puts, use Tesla Motors (TSLA).
Tesla has many fans who think the firm has the potential to become the world’s most lucrative manufacturer of battery-powered autos. However, there were plenty of skeptics who questioned if the company’s market valuation of more over US$750 billion (as of February 2021) was warranted.
Assume, for the sake of argument, that the trader is pessimistic on Tesla and believes it will fall by December. Here’s how the short selling vs put purchasing options compare:
Sell Short on TSLA
- Assume 100 shares are sold short at $780.00 each.
- Deposited margin (50 percent of total selling price) = $39,000
- If TSLA goes to zero, the maximum possible profit is $780 x 100 = $78,000.
- Theoretical maximum loss = Infinite
- Scenario 1: The stock drops by $300 by December, resulting in a $30,000 profit on the short position ($300 x 100 shares).
- Scenario 2: The stock remains steady in December at $780, with no profit or loss.
- Scenario 3: If the stock climbs to $1,000 by December, the loss is $22,000 ($220 x 100).
Buy Put Options on TSLA
- Assume you purchase one put option (representing 100 shares) with a strike price of 600 and a premium of $100 expiring in December.
- Margin needed for deposit = N/A
- Put contract cost = $100 x 100 = $10,000
- The maximum potential profit if TSLA drops to zero is ($600 x 100) – $10,000 premium = $50,000).
- The put contract’s cost is the maximum potential loss: $10,000
- Scenario 1: If the stock drops by $300 by December, the option has a $2,000 nominal gain since it expires with a $120 intrinsic value from its strike price (600 – 480), worth $12,000 in premium – but the net gain is $2,000 because the option cost $10,000.
- Scenario 2: The stock remains unaltered, and the $10,000 is lost.
- Scenario 3: If the stock reaches $1,000 by December, the loss is still limited at $10,000.
The highest potential profit from the short sell is $78,000 if the price falls to zero. However, if the stock only increases, the greatest loss is theoretically limitless. The highest potential profit with the put option is $50,000, while the maximum loss is limited to the amount paid for the put.
It is important to note that the preceding example does not account for the cost of borrowing the stock in order to short it, as well as the interest due on the margin account, both of which may be considerable expenditures. The put option has an upfront fee to acquire the puts but no recurring expenditures.
Furthermore, the put options have a set period to expire. The short sale may be maintained open as long as the trader can put up additional margin if the stock gains and the short position is not vulnerable to buy-in due to the high short interest.
Short selling and utilising puts are two alternative methods of implementing bearish tactics. Both have benefits and disadvantages and may be utilized successfully for hedging or speculating in a variety of circumstances.
Short Selling vs. Put Options FAQs
Can You Short Sell Options?
Short selling is the sale of financial instruments, particularly options, with the expectation that their value will fall.
Can I Short Sell Put Options?
A put option gives the contract holder the right, but not the responsibility, to sell the underlying asset at a fixed price and by a certain date. This also provides the ability to short-sell the put option.
What Is Long Put and Short Put With Examples?
When you purchase a long put option, you anticipate the underlying asset’s price to fall. This is a totally speculative play. For example, if Company A’s stock is now trading at $55, but you anticipate the price will fall during the following month, you may profit from your prediction by purchasing a put option. This implies you are going long on a put on Company A’s shares, whilst the seller is short on the put.
Ashort put, on the other hand, occurs when you write or sell a put option on an asset. Let’s say you believe Company X’s stock, which trades at $98, will drop in the next week to $90 and you decide to make the purchase. 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 short position in a put option is called writing a put. Traders who do so are generally neutral to bullish on a particular stock in order to earn premium income. They also do so to purchase a company’s stock at a price lower than its current market price.
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