Traders can also use both of these tactics to help mitigate portfolio risk. Although buying put options and short selling may seem similar, there are key differences when it comes to their suitability for different trading strategies, and their risk and return profiles.
By understanding the strengths and weaknesses of each tactic, you will be in a better position to profit from their use. Let's dig deeper to determine the differences between them.
Short selling is a popular method traders use to profit from falling prices of securities, such as stocks, commodities, cryptocurrencies, and forex.
The process of selling shares short is more complicated than buying put options. To begin with, a trader who sells a stock short must open a margin account, borrow securities from their broker, and then sell the loaned securities on the open market. When exiting a trade, the trader must buy back the shares in order to return them to the broker. If the trader is able to buy back their position at a lower price than they originally sold it for, then the trade will be profitable.
Equity markets traditionally offer much more favorable bid-ask spreads than options markets. So for traders that expect to get in and out of short positions with high frequency over the course of their trade, selling shares short is often a better option than buying put options. Short selling protects capital loss (on the transaction itself) by reducing slippage.
Another key reason short selling is popular is its flexibility. Traders can use short selling as a way to speculate on the price of individual securities or to create market-neutral trades. The term “market-neutral” refers to a strategy that has the potential for profits regardless of whether or not the security’s price rises or falls. When a trader puts on this sort of trade, they typically construct a portfolio where half the positions are long and the rest short.
Let’s take a look at an example. A trader with exposure to value stocks believes these equities are undervalued relative to tech stocks. The trader sets up a market-neutral position by shorting tech stocks, offsetting his long position in value stocks. If the trader wants to profit, he needs to see a decrease in the price differential between value stocks and tech stocks. Whether stocks in general rise or fall is of little concern to him.
Another appealing feature of short selling is the lack of expiration. As such, short selling is generally a better instrument than put options for trades that need time to develop or whose timeframe is uncertain.
Short-only funds are managed often by professionals who are dedicated to exposing businesses that engage in fraudulent accounting. By studying financial statement footnotes and talking to competitors or suppliers, money managers can identify signs of trouble that investors may have overlooked.
For instance, David Einhorn, founder of $7 billion Greenlight Capital and one of the most-watched investors, shorted Lehman Brothers stock in September 2008, when financial markets were collapsing and earned about $1.7 billion.
Macro traders often short currencies when they believe central banks have made policy errors. For example, in 1992, George Soros, the legendary investor and founder of Soros Fund Management, made $1 billion in a single day by short-selling the British pound. The trade has become one of the most famous of all time, with Soros being named "the man who broke the Bank of England."
The risks involved in short selling are unique from the risks associated with buying puts. When a person short sells stocks, their potential losses are uncapped because the price can move against the trader indefinitely.
Moreover, because shares are borrowed from a broker through a margin, short-selling incurs costs in the form of interest. These costs are not a feature of put options.
A put is an option to sell securities at a predetermined price before a set date. Because put options permit traders to benefit from a potential decline in price, they can be used as an alternative to a short sale. But their unique features make put options a better match for specific use cases.
In the case of a put option, a trader purchases the right to sell a fixed number of an underlying asset at a price and time specified in the option contract. The trader is not obligated to purchase the security, and in fact may trade the option as its value changes before it expires.
The market price of an option is called a premium. It is the sum of both the intrinsic value and the time-value of the option, which is the amount over its current intrinsic value that investors are willing to pay because its value could increase before expiration. The premium changes depending on whether or not the option is in the money and on fluctuations in the value of implied volatility.
The put-buyer will earn a profit in two scenarios: 1) if the price of the security falls below the put’s strike price, minus the value of the premium, before the strike date has arrived. 2) if the implied volatility of the security increases.
By contrast, if the price of the security closes at or above the strike price at the time of expiration, the option will expire worthless. And if implied volatility declines, so too will the value of the put.
Unlike short-selling where investors face the risk of uncapped losses, the maximum loss traders face when they buy puts equates to the value of the option at the time it is purchased.
Put options are ideal for a trader who wants to make a bet on the imminent decline of an individual security who seeks built-in leverage and capped risk, and who is comfortable managing a trade through a fixed timeframe.
For traders who are seeking to use put options defensively, the instruments can be used as an insurance policy to hedge long exposure. For instance, a trader with exposure to tech stocks and who is seeking a way to mitigate the impact of a possible downturn in the sector, might consider buying put options for QQQ as protection If tech stocks fall in value, the gains from the put options will help offset the losses of the original position. Investors commonly implement these strategies during periods of increased uncertainty such as earnings season.
We know that put options are a better choice than options for traders who want to limit risk and maximize return when taking a directional bet on an individual security. Additionally, the process of buying puts has less friction than selling shares short. For example, a put buyer does not need to fund a margin account, and he can make a high leverage bet even if his capital is limited. On the other hand, traders must profit from the underlying asset price movement before the put expires. Otherwise, a trader will lose the entirety of his investment.
When short selling, a trader is never limited by an expiration date. It does not matter how long it takes for an asset's price to fall—the trade can be held indefinitely. As a result, a trader can wait longer for the price to move in his favor. Nevertheless, traders who sell short face the risk of uncapped losses. So in the event that a shorted stock appreciates in value, a trader’s losses can be significant. Additionally, because the position is borrowed through a margin loan, the trader incurs the additional cost of interest charges on the short sale. Consequently, traders are required to pay interest as long as they hold the short position.
Both strategies have their advantages and risks. Traders should determine their investment objectives and risk tolerance before applying these two tactics in real-time. Buying put options is one of the simplest and most straightforward ways to take advantage of falling prices in the short run. By contrast, short selling allows investors to open a position for an extended period of time to wait for gains or cut losses if the price moves in another direction.
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