If you are new to investing on the Stock market, you might not be familiar with the concept of short selling or puts.
Did you know that you can sell Stock during a downtrend without owning it? And that this is actually a strategy used on an almost daily basis by institutional and professional investors?
You also might not be familiar with the fact that both types of investing allow you to trade an asset’s dropping market price.
Most new investors assume that the only way to trade is to purchase an asset at a lower price, wait for the Stock’s price to increase, and sell it at a profit. This is often called taking a long position.
A short sell on the other hand has been used by some of the world’s most prolific and successful traders to make their fortunes. George Soros made one billion dollars by short selling the British pound, and the legendary Michael Burry made a stunning one hundred million dollars by shorting the mortgage bond market, making an additional seven hundred million for his investors.
Using short selling and put options can be part of a powerful investment strategy. This article will give you an overview so you too can use the same tools successful institutional investors use.
What is short selling?
Short selling is how professional investors take advantage of the price drop in a specific market. It is often combined other with financial products to either create a profit or limit risk on already opened positions.
A short sell or put options can open up completely new opportunities and possibilities when used appropriately as markets are dropping. As mentioned in the introduction, legendary traders have used these tools to create immense wealth.
Mechanics of short selling
Short selling usually requires a margin account, where traders “borrow” the asset they are interested in from their broker and sell the lent securities on the open market.
When the assets’ price falls, the investor or trader repurchases these at a lower price and pays the required fees to the broker for the credit extended and profits.
Beyond being a very effective way to trade, many institutional investors use it to limit risk of a long position if markets become volatile in the future.
This is what market experts call hedging.
Risks involved
The biggest risk involved when short selling is the lack of a specific price, which functions as a cap. This means that if an asset’s price reverses, this could hypothetically result in limitless losses.
This is why it is extremely important to have your stop and limit orders in place to protect you from this type of scenario.
Examples
First, we’ll assume that the asset’s price you are looking at is already moving downwards and you have a margin account.
Let’s say your analysis has shown that the bear market sentiment will continue after market consolidation. Once the technical indicators you use have fully confirmed your speculation, you can plot your potential entry and exit points, and your stop loss and take profit limits. Then you can open a short position.
In general, whenever you trade, you should always perform extensive research and analysis, and be aware of the current market conditions.
What are puts?
Puts or put options are a financial product that allow investors and traders to take advantage of a bear market.
They are a type of contract that allows you to essentially short sell, but without the obligation to own the underlying assets.
Depending on the scenario, the benefits put options offer might be a better choice when looking to open a bearish position.
How puts work
The main point of a put option is that the trader speculates that the underlying asset’s price will reach a set price by a predetermined expiration date. If this happens, the option is executed “in the money”, as it’s known in the industry.
There are three main terms you should know when trading put options. The predetermined price is also called the put’s strike price. The option’s price, or the underlying asset’s current market price or intrinsic value and the duration of the option (longer options may carry a higher cost), is called the premium. And finally, the expiration date is when the contract will expire.
The benefit of this type of product is the fact that there is a hard limit on the maximum risk, the only price paid in the case that the position fails is the premium. If the option doesn’t hit the strike price by the date defined in the contract, it will expire worthless, and only the premium paid to the broker by the put buyer is lost.
When a trader enters a put option, it allows them to sell a specific number of the underlying asset within a specified timeframe and price. The holder of the put option even has the ability to sell the contract at an increased value before it expires.
For the put option to be profitable, the price of the underlying asset must go below the strike price before the expiration date, in which case the trader is paid the difference between the current market value and strike price minus the premium.
The main benefit of a put option is the capped maximum loss. You can never lose more than the premium paid when the option was originally sold.
This is also the reason why it is preferred by institutions and professional investors to hedge against future risk of positions that they already have open. If you are unfamiliar, hedging is when a trader opens a position that moves inversely to another open position. The more closely correlated the two inverse assets are, the better.
The logic is very simple. If you were trading Stock X and it dropped two dollars, you would hedge it with Stock Y, which would gain two dollars. Of course, you could also open a long and short trade on Stock X, but that would result in a zero-sum trade.
In the real world, the price of Oil tends to be negatively correlated with Stocks involving logistics, transportation and aerospace, because all these sectors are strongly dependant on Oil.
The disadvantage is the fact that the buyer must have the ability to analyse the market and be relatively confident that the price of the underlying security will drop below the strike price, before the contract expires. Of course, unlike short positions, downside risk is limited.
Examples
If the holder of a put option is relatively confident, as inferred from analysis, that the prevailing drop in the underlying Stock or asset will continue beyond the strike price, but market conditions are more volatile than normal, then a put option can offer the profit potential of a short sell but with limited risk.
Key differences between short selling and puts
The major difference between short selling and put options is the limited risk without the need to set stop loss orders. Without such limits on a short sell position, it may be subject to unlimited risk.
Furthermore, a put buyer does not need to borrow money or margin to exercise their put position.
On the other hand, due to the expiration date, a put option might not take full advantage of an ongoing downtrend, whereas a short position doesn’t have this limitation. With enough free margin and if the market continues to trend downwards, a short sale could stay open an indefinite amount of time.
The strike price is another potential downside of put options. If this price isn’t surpassed by the time the contract expires then the option is considered worthless.
Capital requirements
The capital requirements for short selling and put option is also very different. Although buying puts requires paying the premium upfront, margin trading can carry a much higher upfront cost.
Most brokers have a minimum deposit amount to open a margin trading account, and then a certain amount of your funds will be dedicated to the margin requirements to open your trades and keep them open.
Profit potential and risk exposure
Both short selling and put options have the same profit potential when used in a bearish strategy. The only limitation would be that the put option has a specific timeframe in which it expires, whereas short positions without any risk management measures and enough margin could, in theory, stay open indefinitely.
The downside risks when buying puts is only the premium. With a short position on the other hand, again theoretically, losses may be unlimited without the appropriate risk management measures like stop loss to close the trade if the market moves against you.
Cost comparison
When trying to compare costs there are many variables that contribute. One of the biggest contributing factors is your choice of broker. Especially with a short sell position, brokers offer higher but fixed spreads, while others offer variable spreads that may increase in response to market volatility.
In a purely hypothetical scenario where all things are the same though and no extra fees are applied:
When buying put options, the costs are upfront and locked in. A short sell on the other hand, especially when dealing with variable spreads that increase or decrease according to market volatility, may be more challenging to foresee or calculate.
Commissions, fees, and margin costs
Commissions and fees differ greatly from broker to broker. Most credible brokers are very transparent about their pricing and fees. At PrimeXBT, for example, we publish our fees but also offer some of the most competitive rates in the industry.
Margin only needs to be considered when short selling. This also depends on numerous factors including the amount of leverage used to open the position, the underlying asset, and the type of margin.
Effect of market conditions
If you are trading using bearish strategies, then it is also a good idea to use a momentum or volume indicator to confirm whether the trend is strong and persistent or if there is potential for a reversal.
Although technical analysis is a powerful tool, it only uses past data to make price predictions – and can overlook current conditions, upcoming events or even news being published at the time of your trading.
Although the average investor may not have the investment expertise or investment knowledge held by other financial institutions, having as much information as possible is the best way to be successful.
Volatility and liquidity
Volatility can be detrimental to both short sell positions and a put option. Of course a short sale, especially one that has a stop stop-loss order, is more susceptible to closing due to a momentary price reversal.
A put option will only close if requested by the buyer or if it reaches its expiration date.
High liquidity contributes to market stability and minimises the risk of slippage (i.e. the time needed to execute an order once it is placed). If you are using bearish strategies, either short sell or a put option, these conditions are more desirable as they make markets move more predictably.
Regulatory considerations
As with any type of trading that creates income, it is best to consult your local authorities regarding reporting of income created from capital gains or investment activities.
Which strategy is right for you?
A reasonable strategy balances numerous variables – including profit, timing, current market conditions and risk appetite.
What works now, may not work in a different context, so it is important to be flexible – and these two ways to trade falling prices, are a great way to do so. As mentioned previously, each method of trading, put options or short selling, depends on your own investment goals and the amount of risk you are willing to take to achieve them.
During a bear market, you may want to hedge downside risk of your portfolio holding for a specific amount a time, then a put option is probably the best – since the cost is known and will not change throughout the duration of the contract.
In fact, institutions frequently use a put option to directly hedge risk on their other holdings when Stock prices drop.
If you have a bit more risk appetite and would want to take full advantage of dropping prices, then short selling might be more appropriate.
Conclusion
No matter your strategy, even a market downturn can present numerous opportunities. Using a put option or short selling can help you succeed, much like institutional and professional investors.
If you are confident that the market will surpass a certain level, at which you can set your strike price, and you would like more control over potential risk, then put options might be the best choice.
Conversely, if you want to maximise your profit potential as a Stock falls, short sales might be better as they do not have an expiry date, and hypothetically could be kept open with enough margin for as long as a Stock declines.
With the appropriate measures, you can even protect your investments and Stock trades, by hedging your open positions with short positions or with put options.
Is buying puts better than shorting?
They both have their own benefits and disadvantages, depending on your risk appetite, conditions and the reasons you'd like to trade a downtrend.
Is buying a put the same as selling a put?
No, buying a put allows you to sell the underlying security at a predetermined price, whereas selling a put allows you to buy the underlying assets at a predetermined price.
Is selling a put option long or short?
It is a long position - or a position in which you expect the asset or Stock price to rise.
