Short selling can be dangerous; you can lose more than you expect; a stock’s value can only fall to zero, but it can climb to infinity, so a stock can run forever against an investor betting it’s about to decline.
One way to profit from price declines without taking on this asymmetric risk is with put options. When you use put options to speculate on a fall in a stock’s price, you’re not subject to dangerous events like short squeezes or forced buy-ins. That said, let’s examine how put options can serve as an alternative to short selling.
Put options explained
A put option gives the holder the right to sell a stock, at a specified price — known as the strike — on or before the expiration date. When you’re long a put option, you’re not obligated to sell shares of the stock at the prespecified strike price. However, if you’re long a put option and it expires in the money, or a penny below the strike price, your options would be exercised automatically, and you would end up being short 100 shares of the underlying stock.
When you purchase a put option, your maximum loss is defined; it’s the amount of capital invested in the option. However, when you short a stock, your maximum loss is undefined.
Here’s a look at the payoff diagram, at expiration, of a long put option.
Source: The Options Guide
If you look at the diagram above, your maximum loss is defined, as well as your maximum profit. Again, your max loss would be the amount you invested in the option, while your max profit would be the strike price of the option. The option rises in value — when all other factors remain stagnant — as the stock price falls. There are multiple factors that affect an option’s value, such as implied volatility, interest rates and dividend.
If you’re looking to short a stock, put options can be a better alternative. However, not all stocks are optionable, so put options can’t be used in all cases.
For example, say you’re looking to short the SPDR Gold Trust (GLD) based on your analysis. That said, you pick a strike price and expiration date and purchase a put option. For simplicity, assume you purchase 1 put option with a strike price of $120, expiring in one month. Thus, if GLD falls below $120, your option would be in the money and have intrinsic value; the opposite is true when GLD trades above $120.
Put options serve as a cost-effective alternative to short selling, and they define your risk. The next time you’re bearish on a stock and want to get short, see whether options are available. I won’t tell you that options are easy to grasp and understand, but I will say that you might find them a better and cheaper alternative to shorting a stock.
Jeff Bishop is lead trader at TopStockPicks.com. He runs short-term trading strategies, using stocks, options and leveraged ETFs.