Why Should You Buy Put Options Instead of Shorting a Stock?

Examining the difference between buying puts and shorting a stock

Aug 6, 2015 at 4:36 PM
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What is the difference between buying puts and short selling stock? Glad you asked, as that is precisely what we will look at in today's article.

Short selling is simply borrowing shares of a stock from a broker, then selling them in hopes the security will fall. In this best-case scenario, the short seller can then repurchase the shares at a lower price, "return" them to the broker, and pocket the difference. However, if the stock increases in value, the short seller will have to buy the shares back at a higher price, swallowing a loss.

Confused? Let's look at an example.

Let's say Stock XYZ is trading at $100, and you think it's bound for double-digit territory within the next couple of months. Assuming you have a margin account -- meaning you can borrow from your broker -- you opt to short 100 shares for $10,000 total.

In the next few weeks, XYZ retreats to $95. You then buy back those shares for $9,500, resulting in a profit of $500 for you. Even better, let's say XYZ sinks to $85, and you buy back the shares for $8,500 -- a profit of $1,500.

On the flip side, let's say XYZ soars to $105. Spooked, you repurchase the shares for $10,500 total, resulting in a loss of $500. Even worse, let's say XYZ rallies to $115, in which case your loss would amount to $1,500. And so on and so forth.

In simpler terms, a short seller's profit will increase the further the stock falls, and his risk will increase the higher the stock soars.

Buying puts, on the other hand, echoes the profit potential of short selling, but with limited risk.

Sticking with XYZ -- trading at $100, remember -- you (still bearish) could purchase a back-month, 100-strike put for $4 ($400 per contract, as the option controls 100 shares).

If XYZ falls to $95 by options expiration, the put will gain $5 in intrinsic value -- more than doubling your investment ($400 to $900). Even better, a retreat to $85 would place the put 15 points in the money, meaning it would have $15 in intrinsic value. You more than tripled your investment ($400 to $1,500).

But what happens if XYZ jumps to $105? To $115?

Even if XYZ skyrockets to $1,000 within the options' lifetime, the most you're risking is the initial premium paid ($400). And therein lies the benefit of buying puts over selling a stock short.

 

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