When it comes to short selling, the most common thing to do is use put options or directly short a stock. Both are ways that you can potentially profit when you expect a stock’s price to go down. However, they work in different ways and come with their own set of risks and rewards. In this article, we’ll break down what put options and short selling are, how they compare, and when you might choose to use one over the other.
What Is Shorting
Short selling, or “shorting,” is when you borrow a stock from a lender, typically a brokerage, and sell it immediately in the market. The goal is to buy the stock back later at a lower price, return the borrowed shares to the lender, and pocket the difference. This technique is used when you believe that the price of a particular stock is going to decrease. It’s a way of making profit from falling market prices. However, it’s worth noting that shorting can be risky, as potential losses are theoretically unlimited if the stock price increases instead of decreasing.
What Is A Put Option
A put option is a type of contract in the options trading market. When you buy a put option, you’re purchasing the right (but not the obligation) to sell a specific amount of a security at a set price, known as the strike price, within a certain time frame. Put options are typically bought when you anticipate that the price of the underlying security will fall before the option expires. If the price does fall, you can either sell the option contract at a profit or exercise the option to sell the underlying security at the strike price, which would be higher than the current market price. However, if the price of the security rises or stays the same, the put option will lose value, and the investor could lose the entire amount they paid for the option.
Differences between Put Option and Shorting
Risk Exposure: In short selling, the potential loss can be infinite if the stock price rises uncontrollably, since there’s no upper limit to a stock’s price. In contrast, the potential loss in a put option is limited to the amount paid for the option, as the worst-case scenario is that the option becomes worthless.
Potential Profit: Short selling can provide substantial profit if the stock price falls significantly, but the maximum profit is limited to the price at which the stock was short sold (since a stock’s price can’t go below zero). For a put option, the profit potential is also high if the stock price falls, and the maximum profit is achieved if the stock price falls to zero.
Time Horizon: Short selling can be kept open for an indefinite period, as long as the investor can meet their broker’s margin requirements. However, a put option has an expiration date, after which the option becomes worthless if not exercised or sold.
Margin Requirement: Short selling requires a margin account and you must maintain a certain minimum balance in your account (margin requirement). In contrast, buying a put option does not require a margin account, and the maximum possible loss is the price paid for the option.
Which Should You Choose
The choice between a put option and short selling largely depends on your individual investment goals, risk tolerance, and market expectations. If you’re comfortable with high risk and potentially unlimited losses for potentially high rewards, short selling might be the strategy for you. However, if you’d prefer to limit your potential losses, a put option might be more suitable as the most you can lose is the cost of the option. It’s also important to consider the time frame of your investment. Short selling can be maintained for an indefinite period while a put option has a specific expiration date.
