Put Options or Short Selling: Pros and Cons

Jul 13, 2020 03:36 AM ET
Put Options or Short Selling: Pros and Cons

Put Options and Short Selling are popular bearish strategies used to speculate on the potential decline of underlying assets' prices. The strategy also finds excellent use in hedging against downside risk in investment portfolios. While the two approaches do share some attributes, they also differ a great deal.

What is Short Selling?

Short selling is a trading strategy whereby traders sell an asset that they do not hold in their investment portfolio. A trader opens a short position on the belief that the price of the underlying security will decline over an extended period.

Short-selling entails borrowing shares that one does not own from a broker and selling them at the prevailing market price. The end game is to rebuy the shares at a much lower price when returning to the lender.

Short sellers strive to profit off the difference between the short-sale price and the cost at which one buys back the shares, in what is often referred to as short-covering.

Short Selling

In the equity markets, short selling can be a dangerous play since the long-term trend of the market is often upwards. However, there are situations whereby price might start to move lower, presenting an opportunity to profit from downside action.

Besides, traders leverage short selling as an indirect way to hedge against a long position in a portfolio. For instance, a trader can enter a short position on the NASDAQ index if they are long on a given tech stock, in a bid to protect their portfolio against any downside action.

The rewards with short selling are limited, given that the price of a security or asset can only decline to zero. With long positions, the underlying price can rise to an infinite level. Amid the risks, short selling is an ideal trading strategy during bear markets.

How Does Put Option Work

A Put Option is an alternative trading strategy that allows traders to take a bearish position on security. By triggering Put Options, traders are simply buying the right to sell an underlying asset at a price stated in the contract, often referred to as the strike price before a set expiration date.

Put Option

In this case, a strike price is predetermined at which a buyer can sell security. The value of a Put Option appreciates whenever the price moves below the strike price. However, whenever it stays above the strike price, the Put Options contract would expire worthlessly, and the trader will not incur any cost. 

For instance, a trader can only sell a stock at $10 before the option expires if the strike price is $10. Once the price of the underlying security moves below the $10, the option will be worth money, i.e., an intrinsic value, allowing the trader to sell the option at a profit

What is the difference between Short Selling And Put Options?

The two bearish strategies differ in that short-selling exposes traders to far more risk than buying Puts. With short selling, the reward is limited as the underlying price can only drop to zero. However, the risk with short selling is infinite, as the price can rise infinitely.

With Put Options, a trader can only lose the premium paid on the calls. The potential for profit, on the other hand, is high.

Short Selling And Put Options

Also, short selling tends to be a little bit expensive compared to buying Puts. The margin requirements with short selling make the trading strategy quite expensive. However, with Put buying, there is no requirement to fund a margin account. A trader can initiate a put option even with a limited amount of capital.

One of the most significant drawbacks of a Put Option is that a buyer is always at risk of losing all the capital invested in buying the Puts on a trade failing to pan out.

Put Options vs. Short Selling: Real Life Example

Buying Put Options Example

Whenever a trader is buying a long Put Option, the investor is inherently bearish on the stock with expectations that the underlying price will go down over a given period.

Put Options vs. Short Selling

Assume Apple stock is trading at $150 a share. If a trader is bearish on the stock, thinking that the market price will decrease to around $145, in six months, he or she could buy a Put Option on the stock with a strike price of $150.

Once the price drops before the expiration date of the contract, say to $144 a share, the trader would be able to make a nice profit by exercising the put option contract and selling the share of the stock at $150 a share, instead of the lower price they are worth.

If a trader is moderately bearish on the stock, he or she could buy a Put Option at the $150 strike price backed by a $3 premium on 100 shares. The cost of the contract, in this case, would be $300 ($3 x100). In this case, the trader can only lose $300 on the underlying price, failing to drop below the $150 strike price.

Once the price of the Apple stock drops to $145, the profit, in this case, will be  $5 a share ($150-$145), translating to a profit of (100 shares x $5 = $500 - $300 Premium = $200.

The fact that a Put Option is a contract; it merely gives the trader the option of selling shares instead of having to. Therefore the losses are limited to the amount of shares one wants to sell and the premium paid.

Short Selling Example

Considering the example above, an investor wants to enter a short position on Apple stock on expectation that the price will decline as the company moves to report its financial results. In this case, the investor borrows 100 shares from a broker to short sell the stock at $150.

If a week later, the price would have dropped to $145, the trader can close the short position by buying back Apple stock from the open market at $145. In this case, he will end up with a profit of $5 a share translating to a total profit of $500

However, had the price increased to $160 and the trader decided to close the short position, he or she would have to incur a net loss of $10 a share, translating to a total loss of $1000 (100 shares x $10).

The net loss of a short sell position increases as the price increases from the entry price point. In contrast, a put option limits the net loss on a bearish position to the premium paid.

Conclusion

Put Options and short selling are separate but unique ways of profiting whenever the price of the underlying asset is poised to edge lower. Short-selling entails selling a security that a seller does not own but borrowed and then sold in the market.

On the other hand, a Put Option provides an alternative way to open a bearish position on a security. Likewise, Put Options give buyers the right or option to sell an underlying asset at a stated price upon the expiry of a contract.

Put Options come with a finite time of expiry and loss that one can make, depending on the premium. Short positions, on the other hand, can be held open as long as possible. Similarly, short positions can result in an infinite amount of losses as prices rise.


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