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.

Recommended Articles

‘Healthy’ Foods That Might Be Harming Your Gut and What to Choose Instead

As our world produces and demands more processed foods for convenience, marketers are also getting clever. Foods are being labeled to cater to those with dietary requirements or those looking

5 Surprising Countries Where You Can Retire with Less Than $100,000

When retirement is inching closer, you might wonder about the kind of lifestyle you can lead and the level of financial security you will have if you just have about

fire method for early retirement

The Real Truth About the FIRE Method for Early Retirement

The FIRE method for early retirement has taken off in popularity in recent years. But are the risks well understood by its adopters? Retiring as early as possible then living

Feeling Bloated? 25 Natural Ways to Fix Constipation

We’ve all been there. Things are rumbling in your tummy, you feel big and uncomfortable, but you just can’t seem to poop. Constipation happens to the best of us, and

5 Ways to Ensure You Get the Lowest Possible Mortgage Rate

A 30-year fixed rate mortgage is the most widely chosen home loan option because of the high financial predictability it offers. Follow these tips if you want to obtain the

Robots Will Take 52 Million Americans Jobs. Here’s What Will Happen

A new research report compiled by the Brooking Institution reveals that innovative automation technologies are set to replace millions of American jobs. In fact, more than 52 million American jobs in

Online Loan Companies Are No Easy Fix for Desperate Borrowers

If there is one thing that most Americans need right now, its more money. Online loan companies know this — and it's dangerous for many of us. Since the financial

investing in a volatile market

Investing in a Volatile Market for Long-Term Gains

Investing in a volatile market gives everyone the jitters. Novices, in particular, tend to sell in a panic and then wait for the right time to re-enter the market. Selling

Legumes: Nutrient Dense and Delicious, but Watch for These Preventable Side Effects

Legumes: Good or bad for you? The answer is, a little of both. And at the end of the day, what really matters is how your unique body feels when

4 Keys to Successful Retirement Planning

Retirement planning gives you the freedom to live life to the fullest. You can afford to have all the necessary comforts and amenities of life, go on a vacation occasionally,

Do Seniors Need Life Insurance Coverage?

Do seniors need life insurance coverage? Your golden years should be about enjoying the memories of one’s lifetime. Yet the reality of life is that we struggle to pay our bills

Better Investment Than a Casino? Probably a Fitness Club

We all aspire to be healthier. Who doesn’t aspire to lose weight and exercise more as an annual New Year’s resolution? Yet well-intentioned aspirations and actions are not the same