Short sellers tend to get a lot of bad press — and a lot of blame when stocks go down.
A while back, an editorial in Kiplinger’s that caught my eye talked about the pitfalls of short selling, focusing primarily on the difficulties of finding the right stocks to short. The bottom line, the article claimed, is that the odds are stacked against you.
Well, OK, stocks go up on average over time, the last decade notwithstanding. (Did you know that the S&P 500 is at the same level as late 1997?) And, yes, you can find bear funds that have done poorly over time. No argument there.
But c’mon, let’s be fair. Unless your strategy is to buy a broader-market index fund (or ETF) and walk away for 10 or 20 years, why would you dismiss a strategy that has merits? The market goes up and down. Why not take advantage of the “down”?
But I don’t want to argue the merits or pitfalls of short selling and whether you should do it. Rather, I want to focus on the best way of shorting stocks.
The Pitfalls of Shorting a Stock
The traditional way of shorting involves borrowing shares from your broker and selling them in the open market. Clearly, you want the value of the stock to decline, so you can buy the shares back at a lower price. Your profit is simply the price sold minus the price purchased — pretty straightforward.
But what happens if the stock goes up in price? Your losses start to mount and mount. In fact, your loss is theoretically unlimited, because there’s no limit to how high a stock price can travel. So your loss is capped only when you buy the shares in the open market.
Another problem with shorting is that there’s no guarantee that the stock will be available in your broker’s inventory. So your shorting choices may be limited.
Learn more about the issues with shorting stocks.
The Advantages of Put Options
The alternative to shorting is to buy put options.
A put gives you the right, but not the obligation, to sell the underlying stock at the strike price on or before expiration. Buying a put allows you to lease the downward price movement of a stock.
If a stock is priced at $50 and you buy a 50 strike put, you have the right to sell 100 shares (you either own the shares already or buy them at the market price) of the stock at a price of $50 per share no matter how low the market price. If the stock drops to $40, you can buy 100 shares for $4,000 and sell them for $5,000 using your put. That’s one way to realize a gain.
The other way is to sell your put option for a profit. If you buy a 50 strike put for $2 ($200 per contract) and the stock drops to $45 at option expiration, your put is now worth $5 ($500 per contract). That’s a 150% profit on your initial investment.
Contrast that to shorting a stock at $50. If the price declines to $45, you make $5 per share for a 10% return. This points out one of the main advantages of options — leverage, or more bang for the buck.
The other primary advantage of buying a put is that you’re placing far less cash at risk. Shorting 100 shares of a stock at $50 requires a margin account and an investment of $5,000. But buying a put may require only a few hundred dollars. And the most you can lose is limited to the premium paid for the option.
Of course, the life of the option is limited, whereas the short sale has no defined life. However, the owner of the stock (remember that you borrowed the stock from someone) can call their shares back at any time (although this rarely happens). On the other hand, as a put owner, you control when the put is sold or exercised.
In addition, you are paying a time premium for the put and, thus, the option will suffer from time erosion such that the time value is 0 at expiration. So you’ll need the underlying stock to drop in order to see a gain.
Another advantage of puts is that they’re frequently allowed in retirement accounts, whereas shorting is not. Furthermore, if you short a stock, you are liable to pay the dividend to the person or entity that loaned you the stock. Put buyers pay no such dividend.
The bottom line is that buying a put represents a much simpler way to bet on a stock’s downside movement. You avoid the hassle of finding the stock, creating a margin account, and putting up a lot of cash. The cost for puts is low, you can buy and sell them any time, and they’re freely available and usually very liquid.
I’m certainly not advocating that you run out and buy a bunch of puts. Betting on the downside is not easy, as you’re constantly fighting the market’s upside bias. But if you want to take advantage of a bearish move, buying a put is usually your best bet.
And if you want some help selecting the best ones, be sure to check out How to Pick the Right Put Option.
Jon Lewis is the co-editor of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events. For more information about Jon, read his bio here.