Short Selling vs. Put Options

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If you’re just starting your investment journey, you may not be familiar with the concept of short selling and put options. Both are reoccurring terms in investing. Although the lines of difference between both concepts are often blurred, they’re not the same trading strategy. Here’s everything you need to know about the two.

Short selling and put options are bearish strategies speculators employ in response to a potential decline in underlying assets and securities. Usually, as the share price of the security declines, the short position or put option value rises. These strategies can be excellent ways to hedge downside risk in your portfolio or specific asset class.

Understanding the strengths and weaknesses of each strategy can help you decide which best suits your trading style and the current stock market conditions. Benzinga compares short selling and put options, providing deeper insight into how each strategy can help you realize your investment goals.

What is Short Selling?

Investors typically buy assets or securities that have the potential to increase in value over time so they can sell them and reap a significant return on investment (ROI). They “go long” on these assets. This conventional “buy low and sell high” strategy can work well in a market upswing. If you buy a share of XYZ company at $150 and sell at $200, that’s a $50 profit, excluding commissions. But what if the share price declines or the market goes down? That’s where short selling or shorting comes into play.

Short selling or shorting takes the opposite approach — it bets against the market. Instead of buying low and selling high, you now sell high and buy low. Short selling is when you borrow a tradable asset or security from your broker and sell it at the current market price. You then hope the asset’s price will decline so you can buy back at a lower price and return what you owe your broker while keeping the price difference.

Suppose you borrow a unit share of XYZ at a hypothetical current market price of $150 per share and sell it at that price. That means you now have $150 in your pocket. However, you still owe your broker a unit share of XYZ. If the share declines by $100, you can buy a unit at that price and return it to your broker to cover your short position. That’s a tidy $50 profit — you sold at $150 and bought at $100. If the market keeps moving in your direction, you’ll continue reaping profits from short positions.

While the price of XYZ cannot decline below zero, it can rise indefinitely. This fact makes shorting an investment strategy that carries risk. The strategy is further made expensive by its margin requirements. In margin trade, investors borrow money from their broker to finance an asset’s purchase. To protect their interest, the broker holds a margin account with the investor, ensuring there are enough funds to cover potential losses. Due to its inherent risk, not all brokers offer margin trading. Your broker may require you to have sufficient funds in your account to cover at least 50% of your short position. And as your shorted asset increases in value (not stock price), the broker will increase your margin.

Despite the risks, shorting can be an effective strategy for a bear market since stocks tend to fall more quickly than they rise. The risk potential is lower if the shorted securities are an index fund or exchange-traded fund (ETF). The reason is that the risk of runaway gain is lower for these fund types compared to individual stocks. Short selling is an accepted method for speculation or indirect hedging of long exposures.

What Are Put Options?

A put option offers investors and traders alternative means of taking a bearish position on underlying assets or securities. When you buy a put option, you’re buying the right (not obligation) to sell the underlying asset for an agreed price (strike price) and at a specific time (expiration date). This is an option strategy that allows you to manage the potential downside of your investment. You pay the seller (or underwriter) an amount known as a premium in exchange for that right.

One option is known as a contract and represents 100 shares of the underlying assets. Contracts are usually priced in terms of value per share instead of the total value. For instance, if an option is priced at $1.50 in an exchange, buying the contract will cost $150 (100 shares * 1 contract * $1.50).

Options don’t exist indefinitely, unlike a short. You must exercise your right within the specified timeframe. Depending on the price of the assets at expiration relative to the strike price, an option can appreciate or expire worthless. When the asset’s price is below the strike price, the put option is said to be “in the money.” The owner can exercise their option — selling at the strike price or selling to another buyer at the fair market value. They may not necessarily earn a profit when in the money even though the option has intrinsic value (strike price less asset price at expiration multiplied by the unit share).

The put owner only reaps profit when the premium paid is less than the difference between the strike price and asset price at option expiration. Usually, this starts at the break-even point given by the difference between the strike price and the premium paid. Suppose you purchase a put option for XYZ for a $5 premium with a strike price of $150; at expiration, it declines by $100. Then the option is worth $50, and you have made $45.

If the asset’s price is above the strike price at expiration, the put is out of money and worthless. In this case, the seller gets to keep any premium the buyer paid for the option. A put option is ideal for directly hedging the risk of a decline in a portfolio. The reason is that you can only potentially lose your premium and nothing more, assuming the asset price doesn’t fall. Nevertheless, a subsequent rise in the portfolio may offset part or all of such a premium.

Put options lack margin requirements and so can be initiated with little capital. Its limited timeframe, however, means you will potentially lose your money if the trade doesn’t take off. You also have to factor in implied volatility when buying put options. A highly volatile asset means a much higher premium. In such cases, the cost must justify the risk to the long position or portfolio holding.

What is a Bear Market?

A bear market occurs when a broad market index or asset price drops by 20% or more after hitting a recent high. It is often characterized by a prolonged and persistent drop in investment prices arising from investors’ pessimism or low confidence in the market.

Generally, a bear market commonly describes the overall negative performance of the S&P 500, which is considered the benchmark indicator of the entire stock market. The term can also serve for any stock index or underlying assets with a drop of at least 20% from a recent high.

The stock market can hit a bear run for various reasons — inflationary pressures, geopolitical crises, pandemics, war, over-leveraged investing, recessionary fears and more. For instance, the 2020 bear market was triggered by the global COVID-19 pandemic.

Although predicting or managing a bear market can be challenging, experienced investors can often spot the warning indications. Typically, it begins with a regular and widespread stock market dip, followed by a correction and premature bargain-hunting. Stock prices would have already tumbled by the time the trend becomes apparent to an average investor, making it tricky to manage or mitigate.

A bear market might be unavoidable, but historically, it is short-lived. The average bear market duration from 1926 through March 2017 was roughly 1.4 years with an average cumulative loss threshold of -41% compared to 8.9 years and 468% average cumulative return for bull markets. The pandemic-induced 2020 bear run lasted only 33 days before the market started rallying.

How Do Put Options Help in a Bear Market?

A bear market is characterized by a persistent and prolonged decline in the broader market index and underlying assets or securities. A put option can be profitable in a bear market since it appreciates as the price of the underlying assets or securities declines.

In a bear run, you have two options once the underlying asset drops below the put’s strike price. You can exercise your option to sell the stock at the higher strike price or sell the put option for a profit.

An effective way to max out returns through put options in a bear market is via a bear put spread strategy. Here you buy a strike put and sell a lower strike put such that your maximum loss is limited to your net premium.

How Does Short Selling Help in a Bear Market?

The bear market presents an opportunity for short investors to reap significant returns on investment for the broad market index and individual asset categories. The higher the price decline, the larger the profit margin since profit is determined by the difference between the selling price and repurchase price multiplied by the number of shares sold.

For instance, assume that XYZ company further drops to $50 from a widespread bearish run. Your profit will then become $100 (excluding commission and interest). For $1,000 unit shares of XYZ, that is a $100,000 profit. The more prolonged the bear trend, the more likely the price will decline. For instance, the dot-com bubble lasted for two years, erasing over $5 trillion in IT stock.

Short Selling and Put Options Examples

Short selling and put options are excellent bearish strategies that can deliver massive ROI to investors during a bear run. Both are also great for speculation and hedging. However, despite these similarities, they’re fundamentally different. With regards to risk, short selling is the riskier strategy. The risk is theoretically unlimited since the stock’s value can rise indefinitely. At the same time, the potential reward is limited because the stock price cannot decline below zero.

For instance, the share price of XYZ can only fall to theoretically zero. In which case, you earn a 100% profit. However, if the price reverses, you’re in trouble because you need to pay more to buy back the stock. The price can potentially keep moving up till it enters a short squeeze. However, with the put option, you can only lose the premium you paid for the contract, and the expected reward is high. Furthermore, short selling is made expensive by the margin requirements, unlike put options.

As a comparative illustration, suppose you have 100 unit shares of XYZ at $150 per share, expecting it to decline by December 10 — in the next two months. Let’s review the various scenarios that could play out.

Shorting a hypothetical company XYZ:

• Number of shares: 100 unit shares at $150 per share
• Margin deposit required (at least 50%): $7,500 (100 * $150 * 50%)
• Maximum profit in theory (assume price crashes to $0.00): $15,000 ($150*100 units)
• Maximum loss (in theory): infinite or unlimited

Case 1: Share prices decline by $100 on December 10, and you earn $5,000 ($150 – $100 * 100) in profit

Case 2: Share price remains unchanged by December 10, and you earn $0.00 profit or loss

Case 3: Share price increases to $200, and you lose $5,000 ($150 – $200 * 100)

Buying a put option on a hypothetical company XYZ:

• Number contracts: 1 (100 unit shares at $150 per share)
• Assumed strike price on expiration: $120
• Premium: $10
• Margin deposit required: $0.00
• Cost of contract: $1,000 (100 * 1 contract * $10)
• Maximum profit in theory (assume price crashes to $0.00): $11,000 ( $120 * 100 – $1,000)
• Maximum loss (in theory): $1,000 (cost of the put contract)

Case 1: Share prices decline by $100 by December 10, and you earn $1,000 (intrinsic value – the cost of contract) in profit

Case 2: Share price remains unchanged by December 10, and you lose $1,000 (cost of the contract)

Case 3: Share price increases to $200, and you still lose $1,000

Overall, put options seem to be a more reasonable strategy. Nevertheless, factors like investment expertise, capital, risk appetite and purpose (speculation or hedging) often influence investors’ choices.

Bearish Strategies

Short selling and put options are bearish strategies that investors use to protect against potential losses. Short selling involves selling borrowed assets in anticipation of a price decline, while put options give the right to sell assets at a predetermined price within a specific timeframe. Both strategies have pros and cons, with short selling having unlimited risk but potentially higher rewards, and put options limiting losses to the premium paid. Investors should consider their risk tolerance, market conditions and investment goals when deciding which strategy to use.

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The post Short Selling vs. Put Options by Chika Uchendu appeared first on Benzinga. Visit Benzinga to get more great content like this.