Puts and shorts are common strategies used to mitigate risk and profit from potential declines in stocks and securities. Understanding the difference in puts vs shorts is essential for traders interested in investing using two vastly different methods compared to traditional buying and selling of securities and stocks.
This article will go over puts vs shorts and help readers understand the differences. Let’s begin.
What Are Puts?
Puts are a type of financial derivative known as options. A put option gives the holder the right, but not the obligation, to sell a specific asset (stock) at a predetermined price (strike price) within a specified timeframe (expiration date).
Traders buy put options when they anticipate a decline in the underlying stock’s price. Doing so can protect their portfolio against potential losses or profit from a downturn.
Consider a hypothetical example: You own shares of Tesla, currently valued at $251 per share. Worried about a potential price drop, you purchase a put option with a strike price of $220 and an expiration date of two months. If the stock price drops below $220, you can exercise the right to sell your shares at the higher strike price, mitigating your losses.
What Is Short Selling?
Shorts, on the other hand, involve a strategy known as short selling. Short selling is a strategy where investors borrow shares of a stock from a brokerage and sell them in the market, intending to buy them back at a lower price in the future. This strategy is employed when traders believe a particular stock’s price will decrease.
Consider a similar hypothetical example: You expect Tesla’s stock, currently trading at $251, to decline. You borrow ten shares from your broker and sell them at the current price. If the stock price does drop as you predicted, you can buy back the shares at a lower price, say $220, returning them to your broker and profiting from the difference, in our case, $31 profit per share.
Puts vs Shorts Key Differences
Both puts and shorts operate differently. Essentially, puts allow you to sell a security for a predetermined price before expiration. On the other hand, short selling is a strategy where you borrow shares, sell them, and purchase them later to return them to the original owner. You bank the difference between the initiated sale and the repurchased price if you’ve successfully shorted the share. If not, you lose money.
However, both puts and shorts are trading strategies used to profit from dwindling markets. Let’s go over the key differences by examining the following table:
|Aspect||Put Options||Short Selling|
|Type of Strategy||Options trading strategy||Stock trading strategy|
|Ownership||Holder of the option||Borrower and seller of shares|
|Objective||Profit from downward stock price movement||Profit from declining stock price|
|Risk Profile||Limited risk (premium paid for options)||Unlimited risk (stock price can rise)|
|Potential Rewards||Limited potential profit||Unlimited potential profit|
|Market Direction||Profits only from downward movement||Profits from both downward and general movement|
|Initial Capital Required||Premium payment||None (borrowed shares)|
|Obligation||No obligation to sell stock||Obligation to buy back and return borrowed shares|
|Timing||Options have expiration dates||No specific time constraint|
|Complexity||Requires understanding of options||Requires understanding of short selling|
Both put options and short selling carry their own risks and benefits, and it’s crucial to thoroughly understand each strategy before implementing them in your trading or investment activities.
When to Use Puts?
Puts are valuable when you want to hedge against potential losses in your portfolio or speculate on a stock’s price decrease. They can act as an insurance policy to protect your investments during volatile market conditions or economic uncertainties.
When to Use Shorts
Short selling is suitable for anticipating price declines in specific stocks. It’s commonly employed when market sentiment is bearish and traders anticipate a broader market downturn.
Pros and Cons of Puts and Shorts
To further distinguish puts vs shorts, let’s go over the pros and cons of each:
Put Options Pros:
- Limited Risk: The maximum loss is limited to the premium paid for the option.
- Hedging: Puts can act as insurance, protecting your portfolio against potential losses.
- Speculation: Traders can profit from downward price movements without owning the underlying stock.
- Diversification: Puts offer a way to diversify and balance your investment strategy.
Put Options Cons:
- Premium Payment: Buying put options requires an upfront premium payment.
- Expiration Date: Options have expiration dates, which means they may lose value over time if the stock doesn’t move as expected.
- Risk of Loss: If the stock doesn’t move as anticipated, the premium paid for the option is lost.
Short Selling Pros:
- Profit from Decline: Short selling allows you to profit from a stock’s decline in value.
- Bearish Markets: Can be profitable during bearish market conditions.
- No Upfront Cost: Short selling doesn’t require an initial investment since you’re borrowing shares.
- Portfolio Diversification: Can provide a way to hedge against long positions or balance your portfolio.
Short Selling Cons:
- Unlimited Risk: Short selling carries the risk of unlimited losses if the stock price rises significantly.
- Borrowing Costs: Borrowing shares may involve fees or interest costs.
- Market Timing: Short selling requires accurate timing to enter and exit positions.
- Psychological Stress: The potential for substantial losses can create emotional stress for traders.
Understanding the differences between puts vs shorts is vital for investors or traders. Both strategies can be powerful tools when used correctly, but they also come with unique risks and complexities.
Puts are used to hedge risks, while short selling aims to help traders profit from market declines.
Neither is inherently better; they serve different purposes. Puts hedge risk, while shorts profit from declines.
Puts are related to shorting, but they’re distinct strategies. Puts give the right to sell, while shorting involves borrowing and selling.
Both profit from declines, but a put option gives the right to sell, while shorting involves borrowing and selling shares.
A put option is a type of “long” position, as it benefits from a decrease in the stock’s price.