Short selling and put options are essentially bearish strategies used to speculate on a potential decline in a security or index, or to hedge downside risk in a portfolio or specific stock. Short selling involves the sale of a security that is not owned by the seller , but has been borrowed and then sold in the market. The seller now has a short position in the security as opposed to a long position , in which the investor owns the security.
If the stock declines as expected, the short seller would buy it back at a lower price in the market and pocket the difference, which is the profit on the short sale. Put options offer an alternative route of taking a bearish position on a security or index. If the stock declines below the put strike price, the put will appreciate in price; conversely, if the stock stays above the strike price, the put will expire worthless.
While there are some similarities between the two, short sales and puts have differing risk-reward profiles that may not make them suitable for novice investors.
An understanding of their risks and benefits is essential to learning about the scenarios in which they can be used to maximum effect. As noted earlier, short sales and puts are essentially bearish strategies. But just as the negative of a negative is a positive, short sales and puts can be used for bullish exposure.
Of course, specific risks are attached to short selling that would make a short position on a bearish ETF a less-than-optimal way to gain long exposure. The most common reasons to write a put are to earn premium income , and to acquire the stock at an effective price that is lower than the current market price. One way to do so is to write puts on the stock that expire in say two months.
TSLA as an example. Tesla manufactures electric cars and was the best-performing stock for the year on the Russell index, as of Sept. While the stock had already doubled in the first five months of on growing enthusiasm for its Model S sedan, its parabolic move higher began on May 9, , after the company reported its first-ever profit.
For Tesla, short interest as of Aug. This amounted to Note that short interest in Tesla as of April 15, , was This increase in trading volumes has resulted in the short interest ratio SIR declining from SIR is the ratio of short interest to average daily trading volume , and indicates the number of trading days it would take to cover all short positions.
The higher the SIR, the more risk there is of a short squeeze , in which short sellers are forced to cover their positions at increasingly higher prices; the lower the SIR, the less risk of a short squeeze.
Note that the above example does not consider the cost of borrowing the stock to short it, as well as the interest payable on the margin account , both of which can be significant expenses.
With the put option, there is an up-front cost to purchase the puts, but no other ongoing expenses. One final point — the put options have a finite time to expiry, or March in this case.
Short selling and using puts are separate and distinct ways to implement bearish strategies. Both have advantages and drawbacks and can be effectively used for hedging or speculation in various scenarios. Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance.
Become a day trader. Similarities and Differences Short sales and puts can be used either for speculation or for hedging long exposure. Short selling is an indirect way of hedging; for example, if you have a concentrated long position in large-cap technology stocks, you could short the Nasdaq ETF as a way of hedging your technology exposure. Puts, however, can be used to directly hedge risk. Continuing with the above example, if you were concerned about a possible decline in the technology sector , you could buy puts on the technology stocks in your portfolio.
Short selling is far riskier than buying puts. With short sales, the reward is potentially limited since the most that the stock can decline to is zero , while the risk is theoretically unlimited. On the other hand, if you buy puts, the most that you can lose is the premium that you have paid for them, while the potential profit is high.
Short selling is also more expensive than buying puts because of the margin requirements. A put buyer does not have to fund a margin account although a put writer has to supply margin , which means that one can initiate a put position even with a limited amount of capital. However, since time is not on the side of the put buyer, the risk here is that the investor may lose all the capital invested in buying puts if the trade does not work out. Not Always Bearish As noted earlier, short sales and puts are essentially bearish strategies.
An Example — Short Sale vs. Short sale on TSLA: Because of its many risks, short selling should only be used by sophisticated traders familiar with the risks of shorting and the regulations involved. Put buying is much better suited for the average investor than short selling because of the limited risk. For an experienced investor or trader, choosing between a short sale and puts to implement a bearish strategy depends on a number of factors — investment knowledge, risk tolerance , cash availability, speculation vs.
Despite its risks, short selling is an appropriate strategy during broad bear markets , since stocks decline faster than they go up. Short selling carries less risk when the security being shorted is an index or ETF, since the risk of runaway gains in them is much lower than for an individual stock. Puts are particularly well suited for hedging the risk of declines in a portfolio or stock, since the worst that can happen is that the put premium is lost because the anticipated decline did not materialize.
But even here, the rise in the stock or portfolio may offset part or all of the put premium paid. Implied volatility is a very important consideration when buying options. Buying puts on extremely volatile stocks may require paying exorbitant premiums, so make sure the cost of buying such protection is justified by the risk to the portfolio or long position.
Never forget that a long position in an option — whether a put or a call — represents a wasting asset because of time-decay. The Bottom Line Short selling and using puts are separate and distinct ways to implement bearish strategies.
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