Short selling and buying put options can be used to profit from falling share prices. But what differentiates the two approaches and how do they stack up against each other?
With options, we pay a non-refundable sum of money, known as a contract premium, to gain the chance to profit from a move in an underlying security price.
Buying a call option allows us to profit from upward moves in shares, whereas buying a put option enables us to profit from down moves.
Buying a put option, otherwise known as taking a ‘long-put’ position, provides us with the opportunity to theoretically sell an underlying share at a predetermined price and by a certain date.
In practice, when an option contract position has gone our way, we should be able to simply close the position with one click on our laptop to realise profits.
When we purchase a put option, our maximum loss is always limited to the contract premium.
Profiting from puts
For example, suppose the shares of DriverlessCar Company are trading at $160, as at 1 May. A put option contract with a strike price of $150 expiring in a month from now is priced at $3.
We expect the stock price to fall over the coming weeks; we pay $3,000 to acquire put options covering 1000 shares.
Fortunately for us, at option expiry the share price has fallen to $140. Our put options are now ‘in the money’ with a total intrinsic value of $10,000 and we can now sell them for that amount.
In this simplistic example, the intrinsic value of our put options is equal to the difference between the strike price and the option price at expiry multiplied by the number of shares being covered by the contracts.
As we paid $3,000 to buy the put options, our profit from the position is $7,000:
Profit= $10,000 intrinsic value - $3,000 contract premium = $7,000
While put options can offer attractive returns, the downside is limited. Suppose the share price of DriverlessCar remains in a fairly narrow range before rising sharply at contract expiry to $185 after the company reports strong results from new product launches.
In this case, the put option was unprofitable, or in other words remaining ‘out of the money’.
On the bright side, even though the shares rose sharply before our option contracts expired, our loss is still limited to the $3,000 in premiums we paid at initiation on 1 May. The profit potential on a long put is also limited as a share cannot fall below zero.
While long puts can be used for speculative reasons, they are well suited for hedging the risk of a decline in the conventional portfolios and shares that we hold.
Consider the situation of a fund manager who is compelled by their mandate to always hold a certain percentage of a portfolio in equites during all market conditions, including bear markets.
Gains from long-put positions can be a welcome relief, offsetting at least some of the losses from conventional shareholdings.
At other times, rises in the value of our traditional holdings can easily counterbalance the contract premiums paid for our put options.
It may all sound too good to be true, but the probability of an option contract being ‘in the money' and providing us with a profit in its own right is typically only 25%.
The probability is a function of the volatility of the option and the length of the contract; the higher both these factors are, the more likely it is that the strike price on the long-put contract will be reached.
When it comes to options, volatility could be thought of as our friend – higher share price volatility increases our chances of making a profit. In a low volatility situation, when an underlying share price remains virtually unchanged, we´ve still lost the option premium that we paid at the initiation of the contract.
However, the cost of contracts on stocks with higher volatility will also be greater, reducing our potential for profit.
Buying contracts on stocks with lower volatility, but which we believe hold strong potential for share price movement due to events, can prove to be better value.
Some stocks are a lot more volatile than others, with ‘beta’ commonly used as a measure of share price volatility.
For instance, a share with a beta of 0.9 could be thought of as being 10% less volatile than the market average. A share with a beta of 1.2 is theoretically 20% more volatile than the market.
Like long puts, short selling enables us to profit from downward movements in share prices. As with puts, the potential gains are limited because a share price cannot fall below zero.
However, unlike using puts, the potential losses from short selling are theoretically unlimited.
To initiate a short-selling trade, we must borrow shares and then sell them in the market. If the share price drops as we hope, we can then buy them back at a lower price.
This price difference forms the basis of our profit from the trade. However, if the share price rises sharply, we are fully exposed to the resulting losses.
If the price does rise significantly, we could be compelled to provide additional margin (the money a broker requires as security for a trade) in addition to the initial margin we would have had to post at the outset of the trade.
Margin of error
One advantage of put options is that there is no such margin (borrowing) requirement involved. Typically, 50% of the total sale amount must be posted as margin at initiation of a short-selling trade.
This equates to $80,000 if we had sold short 1,000 shares in DriverlessCar Company when the share price was at $160 on 1 May.
If the share price had fallen to $140 as in the earlier example, our potential profit from short selling would have been:
($160 - $140) x 1,000 = $20,000
If the shares had subsequently risen to $185, our paper loss from short selling would have been:
($185 - $160) x 1,000 = $25,000
In this scenario, the put option contracts appear much more favourable as our losses were limited to $3,000.
Short selling entails less risk when the security being shorted is a market index or an exchange-traded fund (ETF). This is because individual shares carry much more potential for sharper movements.
Regulations have been imposed in recent years to make short selling more transparent. Some of the larger short-sale positions of financial institutions can be viewed on regulators´ websites.
*excludes cost of borrowing stock short or any interest payable on margin account.
On the flip side, short selling offers the advantage of time. Unlike with a put, there is no time limit on the trade, provided of course that we can keep funding any additional margin requirements that may be due to the broker.
While the holder of a put option´s losses are strictly limited to the contract premiums they pay at initiation, an option is highly likely to expire out of the money.
In contrast, the short seller could choose to wait it out if they believe the share price will fall in the long term. While being significantly more expensive than long puts, and with much higher potential losses, the short seller gets the advantage of time.
Short selling or long puts?
Both short selling or long puts can be used either to speculate or as a means to hedge risk.
Due to the risks involved, short selling should only be contemplated by sophisticated investors with deep pockets.
As the risk of loss from a long-put contract is limited to just the premiums paid at initiation, put options are likely to be much more suitable for the average investor.
To learn how short selling can work for your trading strategy watch our video: