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.