Short Sell Stocks and Put Options
Many people invest for the long haul. They may buy stocks, bonds and mutual funds, let them grow for 20 or 30 years and then sell them, content with the long-term growth and average market returns they receive. For others, this is not enough. Market fluctuations and economic downturns leave investors looking for alternatives. Short sales and put options offer the potential to make money even in a down market.
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Shorting Stocks
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Short sales gamble that stock prices will fall. In a short sale, the trader borrows stock from her broker and sells it. When the price of the stock drops, she buys the same number of shares to repay the broker and pockets the difference as profit. For example, suppose you believed XYZ Company was not going to make its quarterly earnings forecast and expected the stock price to drop once quarterly reports were completed. You could borrow 100 shares of XYZ from your broker and sell them at $50 apiece, netting $5,000 in your account. Later, when the stock price dropped to $35, you could buy 100 shares to repay your broker. The difference in the sale price and the buy price becomes your profit: $1,500. However, if XYZ does well, prices could rise, working against you. If the price rises to even $55, you lose $500.
Put Options
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A put option is best thought of as an opportunity. A trader buys the opportunity to sell a stock at a given price -- the strike price -- at a particular time. Put options provide insurance for those who worry a stock price will fall and want to minimize their losses. If you were to buy shares of XYZ Company at $50, you could minimize your loss on a potential slump by buying a put option for $45 that does not expire until after quarter end earnings are reported. If the stock drops to $35, you still have the option to sell your shares at $45, losing only $5 per share rather than $15.
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Using Put Options to Short Stocks
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When you short sell stocks, you always have the risk that the stock price will move against you and you will lose money. You can minimize your loss by using put options rather than borrowed shares to short sell. In this scenario, you buy a put on a stock you do not own. When the price falls below the strike price on your put, you can buy shares, then exercise your put option to make a profit. If XYZ Company is currently trading at $50, you can buy a put option to sell 100 shares of XYZ at $45. The put writer -- the trader who sells the put and holds the stock -- believes he has a good deal because the strike price is below current market price. If the shares fall to $35, you can buy up 100 shares at $35 and exercise your option to sell them at $45, making a $10 profit per share. If the price does not fall as expected, you can let the put expire and your only loss is the cost of the put option itself.
Risks
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Buying a put costs money -- typically a few dollars per share. You must pay this price out of pocket, and if the put expires, there is no way to get it back. In addition, all trades have associated fees that may eat into any profit. Shorting stocks requires that you trade in a margin account -- an account that allows you to pledge securities in exchange for borrowing money and stocks from the broker. These accounts charge interest and require you to keep a certain account balance at all times. You may be required to true up all outstanding positions and pay the value you owe with little notice.
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References
- Schwab: Intro to Covered Calls and Covered Puts; Randy Randy Frederick; July 2010
- TMX: Buying Put Options Instead of Shorting Stocks
- InvestorPlace: What is a Short Option Position?; Michael Shulman; Feb. 2008
- The Options Insider: Put Options: The Best Way to Short Stock; Jon Lewis; Jul. 2009
- "Dictionary of Finance and Investment Terms"; John Downes, A.B. and Jordan Elliot Goodman, A.B., M.A.; 2010
