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

FIRE Your Old Financial Life and Retire Early. Here’s How…

A Chicago flight attendant has hit the news for turning her financial life around. At 39, Bianca DiValerio was nearly broke after a divorce and the sale of several failing

Interview: Rates Will Stay Low, Uber ‘to the Moon’

Don't expect the Federal Reserve to even tap on the brakes anytime soon, says Bob Iaccino, editor of the Stock Think Tank. On Thursday, Fed Chairman Jerome threw cold water

3 Crucial Ways to Keep Your Brain Strong Well into Retirement

For people whose whole life has revolved around using their mind, retirement can be a bind. All of those degrees and awards, the presentation notes, the papers, the grand vision

self employed taxes

Help! I’m Self-Employed and My Taxes Are a Mess!

In the not-so-distant past, the word “gig” was used only to describe the work environment for musicians and comedians who would travel from city to city for performances for one

Your Chances of Seeing a Doctor When You Get Sick Are Falling Fast

New studies have emerged that point to a severe shortage of doctors and other vital health workers is on the horizon for the United States. The first report, conducted by the Association

Iaccino: I Took Profits On Bitcoin, but It Has Nowhere to Go But Up

Bitcoin's pull back from recent highs has not dissuaded Stock Think Tank editor Bob Iaccino from owning the cryptocurrency — but he has taken profits. Bitcoin climbed from below $20,000

Facebook Discloses Secret Rules On What Posts Get Blocked — and Why

Ever had a post on Facebook blocked — by Facebook? For the first time, the company is explaining why. The social media giant has now disclosed the once-secret rules on

Iaccino: Buy the Rumors, Sell the Facts On Biden Transition

Bob Iaccino, editor of the Stock Think Tank, says investors should prepare to "buy the rumor and sell the fact" when it comes to plans of the incoming administration of

financial checklist

12 Crucial Money Steps to Take Now for a Better Year Ahead

The beginning of a new year is an ideal time to reset your finances and work towards a more profitable and productive year. Here is a financial checklist with 12

A Simple Strategy to Live Longer by Quitting Work Yet Still ‘Working’

Some see early retirement as the kiss of death, but one study has shown this to be a myth. Retiring early can actually lengthen your life. A 2017 study published in the

deal on new car

Get a Great Deal On a New Car or Truck Using This Tactic

My lease was up on my 2018 vehicle. I was excited to go car shopping. However, what I realized as I ventured out was that the auto industry also has

Renting vs. Buying: What’s Best for Your Retirement?

A white picket fence surrounding a house with 2.4 children, a dog, a cat, a station wagon. This is the American dream. But owning your own home might not be