Thinking of Short Selling? Buy Puts Instead to Lower Risk

The payout characteristics of short selling are similar to buying puts. The value of both instruments increases when the price of the asset (or underlying asset) decreases.

This is where the similarities end, however. In fact, these two types of trading are significantly different.

Perhaps the biggest difference is the risk. The risk for the put buyer is the premium paid for the put.

Conversely, the risk for the short seller is unlimited. That’s because, theoretically, there is no price cap for stocks.

When investors short stocks, they borrow the shares from a broker and sell them for cash. When short sellers must return the shares, they do so by purchasing at the current market price.

If that price is lower than what they sold the shares for, the short position is profitable.

When the stock price rises, however, short sellers face losses. They must buy the shares back at the higher market price.

The price increase may also trigger a margin call.

If short sellers do not have enough cash in their accounts to cover the losses, the broker may initiate liquidation of other assets to cover the cost. 

Short-selling will require investors to have a reserve of cash to cover any initial margin calls.

When an investor borrows shares, she is required to pay interest on the shares. For short holding periods, this may not amount to much. Interest can be significant for longer periods, however. There is no interest charged for puts.

Finally, selling stocks short has a stigma associated with it. Many believe it be un-American. This stigma is not as prevalent today, but it still exists. 

A better strategy

Puts do not have the same stigma associated with them. Since they are positioned as protecting a stock or portfolio, they escape being labeled as such.

Most investors who want to profit from a decrease in an asset’s price should probably choose puts over shorting. However, the one advantage shorting has over puts is that puts have an expiration date. 

Although brokers can call back shorts at will, it doesn’t happen that often, unless margin calls are triggered. Put buyers always face expiration. If the price of the underlying asset does not drop before the expiration date, the put buyer faces a loss. 

Many traders learn to compare risk characteristics of trades. The risks associated with short-selling is much higher than put buying. However, traders can implement composite strategies to reduce risk.

Along with shorting a stock, the investor may also buy a long call on the stock. In this scenario, the risk characteristics are similar to put buying. If the price rises, the short is covered by closing the long call position. Investors must understand that the call option will expire.

Investors should always weigh the risks associated with any investment. Analyzing risk should be a part of every trading strategy.

It’s not necessarily wrong to choose to sell stocks short over put buying (unless you believe it is un-American). If the risk characteristics make sense for investors, they may feel comfortable with the trade.