Short selling and put options are essentially bearish strategies used to speculate on a potential decline in a security or index, or to hedge downside risk in a portfolio or specific stock.

Short selling involves the sale of a security that is not owned by the seller, but has been borrowed and then sold in the market. The seller now has a short position in the security (as opposed to a long position, in which the investor owns the security). If the stock declines as expected, the short seller would buy it back at a lower price in the market and pocket the difference, which is the profit on the short sale.

Put options offer an alternative route of taking a bearish position on a security or index. A put option purchase confers on the buyer the right to sell the underlying stock at the put strike price, on or before the put’s expiration. If the stock declines below the put strike price, the put will appreciate in price; conversely, if the stock stays above the strike price, the put will expire worthless.

While there are some similarities between the two, short sales and puts have differing risk-reward profiles that may not make them suitable for novice investors. An understanding of their risks and benefits is essential to learning about the scenarios in which they can be used to maximum effect.

Similarities and Differences

• Short sales and puts can be used either for speculation or for hedging long exposure. Short selling is an indirect way of hedging; for example, if you have a concentrated long position in large-cap technology stocks, you could short the Nasdaq-100 ETF as a way of hedging your technology exposure. Puts, however, can be used to directly hedge risk. Continuing with the above example, if you were concerned about a possible decline in the technology sector, you could buy puts on the technology stocks in your portfolio.

• Short selling is far riskier than buying puts. With short sales, the reward is potentially limited (since the most that the stock can decline to is zero), while the risk is theoretically unlimited. On the other hand, if you buy puts, the most that you can lose is the premium that you have paid for them, while the potential profit is high.

• Short selling is also more expensive than buying puts because of the margin requirements. A put buyer does not have to fund a margin account (although a put writer has to supply margin), which means that one can initiate a put position even with a limited amount of capital. However, since time is not on the side of the put buyer, the risk here is that the investor may lose all the capital invested in buying puts if the trade does not work out.

Not Always Bearish

As noted earlier, short sales and puts are essentially bearish strategies. But just as the negative of a negative is a positive, short sales and puts can be used for bullish exposure.

For example, if you are bullish on the S&P 500, instead of buying units of the SPDR S&P 500 ETF Trust (or “Spiders,” as they are better known), you could theoretically initiate a short sale on an ETF with a bearish bias on the index, such as the ProShares Short S&P 500 ETF (NYSE:SH ). This ETF seeks daily investment results that correspond to the inverse of the S&P 500’s daily performance; so if the index gains 1% in a day, the ETF will decline 1%. But if you have a short position on the bearish ETF, if the S&P 500 gains 1%, your short position should gain 1% as well. Of course, specific risks are attached to short selling that would make a short position on a bearish ETF a less-than-optimal way to gain long exposure.

Likewise, while puts are normally associated with price declines, you could establish a short position in a put (known as “writing” a put) if you are neutral to bullish on a stock. The most common reasons to write a put are to earn premium income, and to acquire the stock at an effective price that is lower than the current market price. For example, assume a stock is trading at $35, but you are interested in acquiring it for a buck or two lower. One way to do so is to write puts on the stock that expire in say two months. Let’s assume that you write puts with a strike price of $35 and receive $1.50 per share in premium for writing the puts. If the stock does not decline below $35 by the time the puts expire, the put option will expire worthless and the $1.50 premium represents your profit. But if the stock does decline below $35, it would be “assigned” to you, which means that you are obligated to buy it at $35, regardless of whether the stock subsequently trades at $30 or $40. Your effective price for the stock is thus $33.50 ($35 — $1.50); for the sake of simplicity, we have ignored trading commissions in this example.

An Example – Short Sale vs. Puts on Tesla Motors

To illustrate the relative advantages and drawbacks of using short sale versus puts, let’s use Tesla Motors (Nasdaq:TSLA ) as an example. Tesla manufactures electric cars and was the best-performing stock for the year on the Russell-1000 index, as of Sept. 19, 2013. As of that date, Tesla had surged 425% in 2013, compared with a gain of 21.6% for the Russell-1000. While the stock had already doubled in the first five months of 2013 on growing enthusiasm for its Model S sedan, its parabolic move higher began on May 9, 2013, after the company reported its first-ever profit.

Tesla has plenty of supporters who believe the company could achieve its objective of becoming the world’s most profitable maker of battery-powered automobiles. But it also has no shortage of detractors who question whether the company’s market capitalization of over $20 billion (as of Sept. 19, 2013) is justified.

The degree of skepticism that accompanies a stock’s rise can be easily gauged by its short interest. Short interest can be calculated either based on the number of shares sold short as a percentage of the company’s total outstanding shares, or shares sold short as a percentage of share “float” (which refers to shares outstanding less share blocks held by insiders and large investors). For Tesla, short interest as of Aug. 30, 2013, amounted to 21.6 million shares. This amounted to 27.5% of Tesla’s share float of 78.3 million shares, or 17.8% of Tesla’s 121.4 million total shares outstanding.

Note that short interest in Tesla as of April 15, 2013, was 30.7 million shares. The 30% decline in short interest by Aug. 30 may have been partly responsible for the stock’s huge run-up over this period. When a stock that has been heavily shorted begins to surge, short sellers scramble to close their short positions, adding to the stock’s upward momentum.

Tesla’s surge in the first nine months of 2013 was also accompanied by a huge jump in daily trading volumes, which rose from an average of 0.9 million at the beginning of the year to 11.9 million as of Aug. 30, 2013, a 13-fold increase. This increase in trading volumes has resulted in the short interest ratio (SIR) declining from 30.6 at the beginning of 2013 to 1.81 by Aug. 30. SIR is the ratio of short interest to average daily trading volume, and indicates the number of trading days it would take to cover all short positions. The higher the SIR, the more risk there is of a short squeeze. in which short sellers are forced to cover their positions at increasingly higher prices; the lower the SIR, the less risk of a short squeeze.

How Do the Two Alternatives Stack Up?

Given (a) the high short interest in Tesla, (b) its relatively low SIR, (c) remarks by Tesla’s CEO Elon Musk in an August 2013 interview that the company’s valuation was rich, and (d) analysts’ average target price of $152.90 as of Sept. 19, 2013 (which was 14% lower than Tesla’s record closing price of $177.92 on that day), would a trader be justified in taking a bearish position on the stock?

Let’s assume for the sake of argument that the trader is bearish on Tesla and expects it to decline by March 2014. Here’s how the short selling versus put buying alternatives stack up:

• Short sale on TSLA. Assume 100 shares sold short at $177.92

Margin required to be deposited (50% of total sale amount) = $8,896

Maximum theoretical profit (assuming TSLA falls to $0) = $177.92 x 100 = $17,792

Maximum theoretical loss = Unlimited

Scenario 1. Stock declines to $100 by March 2014 – Potential profit on short position = (177.92 – 100) x 100 = $7,792

Scenario 2. Stock is unchanged at $177.92 by March 2014 – Profit / Loss = $0

Scenario 3. Stock rises to $225 by March 2014 – Potential loss on short position = (177.92 – 225) x 100 = — $4,708

• Buy Put Options on TSLA. Buy one put contract (representing 100 shares) with strike at $175 expiring in March 2014. This $175 March 2014 put was trading at $28.70 / $29 as of Sept. 19, 2013.

Margin required to be deposited = Nil

Cost of put contract = $29 x 100 = $2,900

Maximum theoretical profit (assuming TSLA falls to $0) = ($175 x 100) — $2,900 (cost of put contract) = $14,600

Maximum possible loss = Cost of put contract = -$2,900

Scenario 1. Stock declines to $100 by March 2014 – Potential profit on put position = (175 – 100) x 100 less the $2,900 cost of the put contract = $7,500 – $2,900 = $4,600

Scenario 2. Stock is unchanged at $177.92 by March 2014 – Profit / Loss = Cost of the put contract = -$2,900

Scenario 3. Stock rises to $225 by March 2014 – Potential loss on short position = Cost of put contract = -$2,900

As can be seen, with the short sale, the maximum possible profit of $17,792 would occur if the stock plummeted to zero. On the other hand, the maximum loss is potentially infinite (loss of $12,208 at a stock price of $300, $22,208 at $400, $32,208 at $500 and so on).

With the put option, the maximum possible profit is $14,600, while the maximum loss is restricted to the price paid for the puts, or $2,900.

Note that the above example does not consider the cost of borrowing the stock to short it, as well as the interest payable on the margin account. both of which can be significant expenses. With the put option, there is an up-front cost to purchase the puts, but no other ongoing expenses.

One final point – the put options have a finite time to expiry, or March 2014 in this case. The short sale can be held open as long as possible, provided the trader can put up more margin if the stock appreciates, and assuming that the short position is not subject to “buy-in” because of the large short interest.

Applications – Who Should Use Them and When?

• Because of its many risks, short selling should only be used by sophisticated traders familiar with the risks of shorting and the regulations involved. Put buying is much better suited for the average investor than short selling because of the limited risk.
• For an experienced investor or trader, choosing between a short sale and puts to implement a bearish strategy depends on a number of factors – investment knowledge, risk tolerance, cash availability, speculation vs. hedging, etc.
• Despite its risks, short selling is an appropriate strategy during broad bear markets, since stocks decline faster than they go up.
• Short selling carries less risk when the security being shorted is an index or ETF, since the risk of runaway gains in them is much lower than for an individual stock.
• Puts are particularly well suited for hedging the risk of declines in a portfolio or stock, since the worst that can happen is that the put premium is lost because the anticipated decline did not materialize. But even here, the rise in the stock or portfolio may offset part or all of the put premium paid.
• Implied volatility is a very important consideration when buying options. Buying puts on extremely volatile stocks may require paying exorbitant premiums, so make sure the cost of buying such protection is justified by the risk to the portfolio or long position.
• Never forget that a long position in an option – whether a put or a call – represents a wasting asset because of time-decay .

Short selling and using puts are separate and distinct ways to implement bearish strategies. Both have advantages and drawbacks, and can be effectively used for hedging or speculation in various scenarios.