Last week a reader asked an excellent question that deemed a reply that was more complete than what I could provide in a comment. First, thank you for the question and the opportunity to provide you with some insight. The question posed to me was with a market correction or the emergence of a bear market would short selling be a prudent way to take advantage of falling prices in the market. Well, here is the answer short selling is a way to profit from a falling market, but that does not mean it is the safest or only way to profit from this situation.
There are two basic ways to profit from falling prices in the market that produce similar results, but one has limited potential for losses, and the other does not. These two methods are short selling and the use of put options, and we will examine the potential gains and losses of each. What these two techniques have in common is that they are bearish techniques used to speculate on the decline in a security or index. They can also be used to hedge the downside risks associated with a portfolio or specific equity.
First, short selling involves the sale of a security that is not currently owned by the seller and has been borrowed and then sold in the market. The seller now has what is known as a short position in the equity as compared to owning it for the long-term. In order to profit from the short sale, the stock must decrease in value; then it is bought to repay the borrowed shares that were initially sold. The original selling price and the price at which the shares were repurchased are the potential profits. However, if the price increases the losses are limitless, but more on that later.
The second method is buying put options in the open market. The main difference is a put option gives the purchaser of the option the right to sell the equity or index at the strike price on or before the expiration date of the put. If the equity or index decreases below the strike price the value of the put option increases allowing you to either sell the option or exercise it. Now, if the price of the equity or index increases above the strike price, the put will expire worthless, and the losses are limited to the purchase price.
Now we will examine the similarities and differences of short selling and buy put options. As alluded to earlier both are strategies used to take advantage of bearish conditions in the markets, equity or an index. They can also be used to hedge yourself in long positions you may hold to reduce the risk of large losses. Short selling is far riskier than using put options as in short selling profits are limited as the price can only go to zero while losses are unlimited as the stock can go as high as the market allows. With put options, the potential profits are similar to those of short selling while losses are merely limited to the purchase price of the option itself. And finally, short selling is generally more expensive than purchasing puts as they require the use of margin accounts.
Now puts can also be used in a bull market but they are a bit more complicated, and I will not go into great detail on them. But in a bull market, you can buy puts in an index fund that is short exchange-traded fund. How that works is a short exchange traded fund will go down if the market goes up and a put would counteract that by also going up as the value of the short exchange-traded fund has decreased. The act as opposites and that is how they produce a profit for you. I do not recommend this approach to people who are not experienced traders as they are extremely complex much like a short sale is much riskier.
Now we will examine the potential profits and losses of short selling or buy put options in Home Depot on January 31, 2018. We will look at the short sale of 100 shares of Home Depot first then 100 put options of the same. On January 31, 2018, the closing price of Home Depot was $200.90 meaning 100 shares would have cost you $20,090. If you did not have the purchase price, you would have to use a margin account which means you need to post $10,045 or 50% of the purchase price. In margin accounts as in a loan, there is interest owed on the amount borrowed for the length of time the short sale is in progress. We will ignore the costs of using margin accounts for simplicity reasons. With the of the 100 shares you have a profit maximum of $20,090 if the stock price goes to zero and in theory, you have nothing to repay. But what if the price only drops $75 a share? That means you are buying back the shares at $125.90 or for $7,500 less than what you borrowed them at meaning your profit is the $7,500 price decrease. If the price goes nowhere, you owe nothing to repay the person you borrowed the stock from. But if the price goes up $75 you are repurchasing the shares back at $275.90 or a loss of $7,500. As you can see, in a short sale your profits are limited to $20,090 but your potential losses are limitless as the price of the stock can go up is limitless.
Now on to the use of put options on Home Depot’s stock. The price of a Home Depot put with a $200 strike price was $12 on January 31, 2018, or $1,200 for 100 put contracts, they are sold in lots of 100. That is what is compared the margin account on a short sell. Now if the price of the stock goes to zero as with the short sale your profits are going to be $20,090 minus the $1,200 for a profit of $18,890. If the price falls $75, your profits are going to be $7,500 minus the $1,200 for a profit of $6,300. And unlike the short sale if the price stays the same or goes up $75 your losses are limited to the $1,200 you paid for the 100 put options at $12 an option.
As you can see, the potential profits are basically the same for the short sale and the use of put options minus the cost of the options. To me, the cost of the put options as a safety measure, when compared to short selling, is well worth the cost when you consider the potential losses each can create. In my example, the use of options only costs you $1,200 in potential profits but can save you thousands in potential losses if equity or index continues to appreciate in value. Depending on how much risk you wish to take will determine the cost of your put options as out of the money options will cost less than an option that’s strike price is closer to the price of the underlying security.
Short selling is a high risk and limited reward investing strategy for a bearish market. The use of put options lowers the risk of the cost of the options being your risked capital with the same basic upside for potential profits. So, if you want to capitalize on a bearish market, I would recommend the use of put options over the use of short selling for the average investor.
Thank you to BMKAPLAN for the excellent question. And as always, if you have any further questions, please feel free to leave a comment or contact me directly.
