There are several ways to profit when a stock plunges, and shorting and buying puts is among the most common. But what are their differences?
In this article, we will go over the advantages and disadvantages of shorting vs puts.
What is shorting?
Shorting involves borrowing shares, and selling them short hoping that the price will decline, and you can buy them at a lower price, while you pocket the difference. Short selling involves having a margin account, and you will need to pay a stock loan fee in order to borrow those shares.
The fact that you need a margin account in order to short a stock comes with several risks. The main one is a potential margin call, that can wipe the entire value of your portfolio, and even put you in debt.
Shorting is a way for investors to profit from a decline in the stock price, but you can also get short exposure and profit from stock price declines with options.
What is a put?
A put is an options contract that gives the holder the right but not the obligation of selling a certain number of shares for the agreed strike price until the option expires. Puts are one of the most common options contracts used to speculate on stock price declines.
How shorting vs puts works
When you short a stock you borrow the shares you want to short from your broker, who charges you a borrowing fee. There is an interest payment you need to make on the total amount of shares you have borrowed.
To get short exposure to a certain stock with options there are two main ways of doing it:
- Buying a put
- Selling a call
Options give you the right but not the obligation of exercising the option until the date of expiration for the agreed strike price. This means that if you buy 1 put contract you can sell 100 shares of that stock until the expiration date, and for the agreed strike price if you decide to exercise the option.
When you sell a call (sell to open) you are essentially giving the buyer of the call the right to purchase shares at a certain price until the option expires. This involves considerably more risk since the stock can go higher and higher, and you still have to buy those shares (if it's a naked option selling) to deliver if the option is exercised. Or you can buy that said option you just sold, in what is commonly referred to as buy to close.
Advantages and disadvantages of shorting
When we compare shorting vs puts, there are a few important advantages:
- You do not need as much capital
- You can hold your short position longer
One of the main advantages of shorting instead of buying puts is that you do not have to commit any capital upfront. All you need is a margin account, and you need to pay the fee to borrow the stock.
Another advantage is that when you short a stock, you can keep that position as long as you keep paying the stock loan fee, and the stock does not go up significantly.
The major disadvantage with shorting is that your losses can be unlimited. Since the stock you are shorting can shoot up in price, this is a major risk with shorting, and one of the reasons some investors avoid it.
Advantages and disadvantages of puts
Puts force you to buy the options contract upfront, and you need to commit more capital. However, when it comes to losses the most you can lose is your initial investment. As opposed to shorting where your losses can be unlimited.
With puts, you need to pay a premium which varies depending on the demand for that option and the maturity. Usually the longer the expiration date, the higher the premium will be.
Even if the price of the underlying asset declines significantly, you might still not make any money on your puts. It also needs to drop significantly, so that you can recover the premium you initially paid.
Puts also tend to be illiquid depending on the liquidity of the underlying asset, and they can have very wide bid-ask spreads. This makes it difficult to trade certain options, and it could impact your potential profits.
Is shorting the same as a put?
Shorting is not the same as a put. Although both approaches can generate profits if a certain stock declines, they work differently and have different advantages and disadvantages.
Can you short a stock without options?
It is possible to short a stock without options, but it is important not only how shorting works but also to compare it with options.
When you think a certain stock will trade lower, you can get short exposure to it. This means that if the stock declines, you can make a profit. There are two main ways of getting short exposure:
Let’s look at the main differences between these two approaches and their advantages and disadvantages.
Do you need options to short a stock?
No, you do not need options in order to short a stock. Although options also allow you to short stocks, they are not required to do so.
Can you short a stock that doesn't have options?
Yes, you can short a stock that does not have any options as long as there are shares available to borrow, and you have a margin account, and pay the stock loan fee.