Are you feeling generally bearish considering the ongoing state of the market?
After a long, epic bull run, the market is experiencing a colossal pull back. Throughout the year 2022, the S&P 500 has gone down by approximately 20%.
This made 2022 the S&P’s worst year since 2008. It’s tough to trade in such market conditions, right?
While that’s certainly true, there are different ways to capture profit in bear markets and chop environments. Short selling and put options are perhaps the most popular ways to take advantage of falling prices. Yet, there are crucial differences between shorting and using put options which traders must understand.
In this article, we’re going to explain these two strategies in depth so that you can understand them better—and hopefully capitalize on the benefits they offer.
What you’ll learn
Quick Refresher on Options Trading
Options contracts don’t represent assets themselves, but are in fact derivatives of assets. They serve as an investment vehicle which is tied to what’s referred to as the underlying security. Using this vehicle, investors are given the right (but not the requirement) to buy or sell the asset the option is associated with, at a set price over a set period of time.
There are two fundamental types of options contracts: a “call” and a “put”; calls are bullish strategies, and puts are bearish strategies. A single options contract represents 100 shares of whatever underlying security it’s associated with.
Let’s break down an example of how an option would look on a trading screen and analyze its components. These are crucial terms to understand if you are considering trading options.
Let’s say you’re looking to purchase an MS Put with a strike price of $100, an expiration date of April 30, 2024, and a $2.50 premium.
- Ticker Symbol: MS – this is the ticker symbol of the security that the options contract is associated with. MS (NYSE:MS) is the stock ticker for Morgan Stanley.
- Expiration Date: April 30, 2024 – this is the date the contract will expire. Remember in the definitions of calls and puts you have the right to buy or sell stock “over a set period of time”. Your right to buy or sell is between when you buy the contract, and its expiration date.
- Strike Price: $100 – This is the price at which the contract allows you to buy or sell the underlying security.
- Type of Contract: Put – This annotates whether it is a call or a put contract.
- Premium: $2.50 – This is the price you pay for the contract per 100 shares. So in this example the premium is $2.50 per share, so the total price, or premium for the contract is $250.00.
The last set of information associated with basic options trading is knowing whether the contract is in the money (ITM), out of the money (OTM), or at the money (ATM). ITM contracts will cost the most, meaning they have higher premiums than ATM, or OTM contacts. OTM contracts have the lowest premiums of the three.
The way to determine if a contract is ITM, OTM, or ATM, is to compare the current underlying price of the security the contract is associated with to the options strike price.
We’re looking at puts today, so we’ll just talk about those. If a put’s strike price is above the current underlying price, the contract is ITM, because of course it would be better to be able to sell the stock at a higher price than what it is currently trading at. And visa versa, a put would be OTM if the strike price was below the underlying price.
ATM, for both calls and puts, means the strike price is the same as the underlying price.
Put Options Explained
A put is the inverse of a call. Where a call allows you to buy shares at a set price over a set period of time, puts allow you to sell the shares at a set price over a set period of time. Here’s a different way to think about it: put options give you the right to “put” shares onto someone else. Makes sense, right?”]
When Should You Consider Buying Puts?
Puts will earn an investor profit when the security they’re associated with declines in price, therefore they should be used when an investor feels bearish. Here’s an example: say you think Netflix’s price is going to fall because you read in the news that they might increase their monthly subscription fee.
Let’s imagine the current market price for Netflix stock (NASDAQ:NFLX) is $185, so you decide to purchase a put option at a $190 strike price. If the price falls, the value of the put will increase, and you can sell the contract to close the position and profit from the difference in premium.
Another great situation to use put options is when you want to hedge a long position you have taken. For example, if you long 100 shares of Tesla (TSLA) and you want to protect that investment in case TSLA’s price falls, you can purchase a put option along with the 100 shares you long.
In this way, you are protected if the price goes down because you lock in a price to sell the 100 shares, as opposed to being forced to sell at the current market price. Here, put options can be used as a means of hedging or risk management.
What Exactly is Short Selling?
Short selling is when an investor borrows shares from their brokerage, and then sells those shares on the stock market. The way to earn profit with short selling is to buy the shares back for less than you originally sold them for. This is why this is considered a bearish strategy, because you hope that the security’s price will fall.
When is Short Selling a Good Idea?
In general, the best time to consider short selling is when you predict that the price of a security will fall. Both put options and short positions capture profit as the assets price declines. You don’t always just have to open short positions, though – they can be used in combination with other investments. An example of this is if you have long positions open but you want to capitalize on short term pullbacks.
Say you scooped up some Amazon (AMZN) shares and you plan to hold on to the shares long term. Because you’re holding the shares long term, and also because AMZN does not pay dividends, you won’t earn any profit until the price rises and you liquidate the shares. You can, however, profit in the short term by short selling if you notice small pullbacks in its price.
Another great time to short sell is if you want to hedge against long positions you own. This works almost the same way as the example above, the difference being that you aren’t focused on profiting from pullbacks. What you’re doing instead is basically setting up an insurance policy for the long positions in the case that the price falls unexpectedly.
For example, say you long shares of Johnson & Johnson (JNJ) and want to protect those positions by short selling shares. You can short sell an equal amount of shares, or less or more, depending on how confident you are in the future direction of the price. Let’s say in this example you short as many shares as you long, creating a balanced position.
A week after you enter your positions, JNJ’s price drops. At this point you haven’t lost or gained anything, but you can take advantage of your short positions by closing some (if you aren’t sure if it will keep falling), or all of them and realize some nice gains.
Short Selling vs. Put Options – Compared
One major difference between short selling and put options is the degree of ownership. Namely, when you enter into a position with a put, you long that position, meaning you own it. Whereas with short selling, you borrow and sell shares you don’t actually own.
As we’ve touched on already, a key similarity between short selling and put options is that they are both bearish plays, as they both profit if the security’s price falls.
It should also be noted that newer traders with little experience will likely be unable to use sophisticated order types involved in shorting stock or even purchasing put options. When a trader first signs up with an options trading brokerage, the broker will ask the trader a series of questions including income levels, net worth, risk exposure, and experience in trading options. The broker will then assign a certain level of options trading based on the trader’s responses.
Understanding when to execute a short or a put is difficult – timing is everything in the world of options trading. Many traders – both newer traders and experts alike – choose to receive options trading signals from teams of veteran traders. Here at TheTradingAnalyst, we provide such services. For now, to help you better understand shorting and put options, let’s turn to an illustrative example.
An Example of Short Sale vs. Put Options
Let’s say that an investor simultaneously enters into a short sell position and a long put position. We’ll use Apple (AAPL) in this example and see how the two strategies will profit.
Assume the market price for AAPL is just under $145. So you short 100 shares of AAPL and also purchase one ITM put option at a strike price of $146 and an August 12 expiration date, about one month after you enter into the position. The premium is $6.60 per share ($660.00 total for the put).
Three weeks later, the price has fallen to $138.00.
Calculating the profit with the short shares:
$145 – $138 = $7
$7 * 100 = $700 total profit.
Calculating the gain/ loss with the put:
Option pricing is pretty complex, as there are several factors at play. Arguably the most important is time decay, which is measured via Theta. Basically, the closer you get to the expiration date of an option, the more the premium of the option falls. The graph below highlights this concept. Without getting too into the nitty gritty of the change in the premium of the put, we’ll just say the premium goes up by $1.50 per share.
Now, you have two options when closing the put position. Technically you have three, you could let it expire worthless, but since you have the chance to profit if you close it, it makes no sense to do so in this scenario.
The first option is to flip the contract, as in sell it to another trader and make a profit from the difference in premium. You profit equals the difference between the premiums, times 100, minus any fees/ commissions paid: [($8.10 – $6.60) * 100] = $150.00. This is a pretty great return for only having spent $660.00.
The other option you have is to exercise the contract, which means you use the rights of the contract (you sell 100 shares of AAPL at $146.00). Exercising contracts can become quite costly, as you have to own 100 shares of the underlying security. This is a huge reason why options are exercised less than 10% of the time. Here’s how to calculate profit/ loss:
You buy 100 shares of AAPL at $138 = $13,800.
Remember you have to factor in the premium you spent: $660.00
Lastly, exercise your right to sell 100 shares of AAPL at $146.
$14,600 – $13,800 – $660 = $140.
Now, while you did earn significantly more from the short sale, the position was exposed to infinite risk. Even the most fearless investors don’t want to be exposed to that level of risk. To protect the position, shares of AAPL need to be bought. If you had purchased 100 shares, you would’ve spent $14,500. This means that your percent return would be < 5% (4.83%). While your put position ROI would be 22.72%.
This example clearly highlights the leveraging power of options. You do have the choice to spend less with short positions, but we’ll get into that in the next section.
Pros and Cons
As with every investment strategy, there are both benefits and drawbacks to them. A lot of times those depend on the specific circumstance, and other times there is clearly an advantage or disadvantage, such as the advantage of risk being capped with puts.
Risk is capped with puts because your max loss is capped. Your max loss is equal to the amount of premium you paid for the put(s), can’t possibly lose more than that. In contrast, with short selling your max loss is unlimited, as a stock’s price has no limit to how much rise. While it’s unlikely for the price to just randomly skyrocket, it’s still not a good idea to expose yourself to that amount of risk, especially in today’s volatile market.
Now while your max loss is capped with puts, so is the time you can hold the position. This can be seen as a disadvantage. Options have expiration dates, but shares you long and short do not. Time decay affects the value of options, especially as it gets closer to the expiration date as we saw in the graph above. Short potions can be open as long as you want them to be, and time decay does not factor into their value.
The learning curve for puts is a little steeper than it is with short selling. This acts as a barrier of entry for some traders. Short selling is pretty straightforward, so it is relatively easier to effectively start short selling than it is to start buying puts. Learning how to trade puts requires the investor to understand a whole new set of terms and apply that knowledge to every trade they make.
The last thing to note is the difference in returns versus the money spent on the position. Puts essentially allow you to have control over 100 shares of a security for a fraction of the price it’d take to buy those same shares. This magnifies the gains (but also the losses) you can make when using options. You have to spend a considerable amount more to earn the same profit with short selling.
This might appear to be a clear advantage for puts, but let’s say you only have a couple hundred dollars to use to invest. This severely limits what puts you can buy. Here’re a few examples using popular stocks:
- A Tesla (TSLA) put (current shares price $700) would cost $5,525.
- An Amazon (AMZN) option contract = $655.
- A Microsoft (MSFT) contract = $1,065.
- Alibaba (BABA) options contract = $815.
- Gamestop (GME) options contract = $2,180.
You get the idea. Puts can be quite expensive for those that either don’t have, or don’t want to spend more than a few hundred dollars in the market. But, if you want to get your feet wet and start trading for small amounts of money, perhaps to just learn out of curiosity, practice, etcetera, short selling could be a great choice. This is made possible by what are called fractional shares.
Fractional shares allow you to enter a position for, well, a fraction of the cost. For example, say you want to get into a TSLA position because you want to see what all the hype is about, but you don’t want to spend more than $200. If the current share price is $700, and you invest $200, you will have a fractional share with a little less than 30% of one full share. So for every dollar the stock goes up, you would make about $0.30 ($0.285 to be exact).
Using Short Sales and Puts in Bullish Market
What’s the advantage of using bearish plays in a bull market? It is common to utilize bearish plays such as put options and short selling in bullish markets to hedge/ protect/ insure bullish positions. With put options, a well known play is referred to as a “married put”.
A married put is when you purchase a put option to ‘tie’ it to shares you long. Since one option contract represents 100 shares, the best way to execute this play is for every 100 shares you long, purchase one put. You don’t have to do it this way, but it is the most balanced approach.
For many investors, this may not be a viable option due to a lack of capital. If you wanted to use this play with Costco (COST), the 100 shares alone would cost more than $50,000 as of July 2022. With shorting fractional shares, however, investors can save a lot of capital. You can long shares of a stock you want, and hedge them with an equal number of shares you short, and spend however much you are comfortable with.
The largest similarity between short selling and put options is that both of them can capture profit when a security’s price falls. Your choice in using one strategy over the other depends entirely on the situation. Some of the factors that will play into your decision include how much capital you want to spend, and how much risk you are comfortable with taking on.
Options are leveraged, meaning you can earn more and spend less. But if you don’t have several hundred dollars (or more) to get a put option on a blue chip, you can consider short selling.
It is crucial to protect your position if you choose to short sell. You don’t necessarily have to long as many shares as you short, that is just the most balanced approach. Remember, risk equals reward, but also loss. The more risk, the higher the potential reward or loss. This highlights a benefit of puts: max loss is capped. So the absolute worst case scenario when buying puts is that you lose the money you initially spent to enter the position.
If you have some money to play with, try exercising both strategies and see which one is right for you, or which one is better given different scenarios. There are plenty of puts that cost far less than the example we had provided. So explore your options (pun intended) and dive in!
Short vs Put: FAQs
Is a Short the Same as a Put?
No, a short is not the same as a put. Put are derivatives of assets, so they are not technically stocks at all. Moreover, when you short sell, you borrow money from your brokerage to buy shares you don’t actually own and then sell them. Whereas with a put you actually own the position, or contract.
Is it Better to Short or Buy Puts?
Whether it’s better to short or buy puts depends entirely on the specific circumstance. One is not inherently better than the other.
One example when shorting makes more sense is when a trader has a relatively low amount of capital: Puts can be expensive, far more expensive than fractional shares of a security, so if you don’t have that much capital, short selling might be the way to go. Just make sure to protect the potions by longing some shares too, as short selling, theoretically, has unlimited risk.
Is it Possible to Short Sell Options?
Yes, it is possible to short sell options. But the mechanics work entirely differently. Meaning, when you short sell stocks, for example, you are bearish, hoping the price will go down to earn a profit. But with shorting options, you earn a premium when you short an option, and your goal is to keep that premium. This premium is often best kept if the price of the underlying asset stays relatively stable, which is not what you’re hoping for when you short shares of securities.
Can You Short Sell Put Options?
Yes, you can short sell put options. Shorting options are also referred to as writing options. So you can ‘write’ a put.
What is a Short Position in a Put Option?
There is no such thing as a short position in a put option. Put options and short positions are two different things.
When Should You Buy Puts?
You should buy puts when you feel bearish towards a potential position. Or, if you feel bullish and have a long position held, then buying puts can be used as a means of risk management to hedge against your long position, and protect yourself from losses.
Why Would I Short Instead of Using Put Options?
There are several reasons why you could short instead of using put options – all are entirely circumstantial, as one strategy is not objectively better than another. One reason you could buy a put over shorting is because your max loss is capped at the price you paid for the options. Whereas with shorting, your max loss is theoretically infinite.