Brocker.Org: Short Selling Alternatives

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Investors who wish to act on a bearish view with regard to a stock, sector, or the broad market, have a couple of alternatives to short selling: put options and inverse exchange-traded funds (ETFs).

Put Options

Put options are a less risky way than short selling to speculate on a bearish view or hedge downside risk. The purchase of a put option confers on the buyer the right to sell the underlying security at the put strike price, on or before the put’s expiration. If the security is trading below the strike price by expiration, the put will appreciate in price. However, if the security rises above the strike price by expiration, the put will expire and be worthless.

Three benefits of buying a put option in comparison to making a short sale are:

  1. Puts have a much better risk-reward profile compared to a short sale, with risk limited to the premium paid and potentially high reward. For instance, say a one-month put option is purchased on a stock trading at $12, with a strike price of $8, for a premium of $0.25. Why would a trader buy such a deeply out-of-the-money option? Perhaps because the trader is speculating that some negative event in the very short-term will drive the stock sharply lower. Let’s say the company reports disastrous earnings within the next couple of weeks and as a result, the stock plunges to $3. The put options will now trade at a minimum price of $5 (strike price of $8 – current stock price of $3), resulting in a 20-fold return on the initial investment. A trader who had purchased 10 put option contracts for an initial outlay of $250 would rake in $5,000 on this trade, while only risking the premium paid of $250.
  2. Puts do not have many of the costs and risks associated with short selling. Unlike short sales, put purchases do not have to supply margin (although put writers have to do so), and do not have to contend with hard-to-borrow costs and dividends payments, or the risk of short squeezes and buy-ins faced by short sellers.
  3. Puts can be used to directly hedge downside risk on long positions in a specific stock, an entire portfolio, or the broad market. Short selling is at best an indirect way to hedge long exposure.

Inverse ETFs

Inverse exchange-traded funds are ETFs that seek daily investment results that correspond to the inverse of the daily performance of a security, such as a sector or market index, commodity, or currency. Leveraged inverse ETFs offer double or triple the inverse of a daily return. While inverse ETFs may be a better alternative to outright short sales because of their lower cost and better risk profile, they cannot be used to directly hedge downside risk in a specific stock. Overall, protective puts probably offer more utility for the average investor in terms of their simplicity and uncomplicated risk-reward profile.

Short selling

Put options

Inverse ETFs

Risk Level

Risky

Risky

Risky

Downside

Unlimited

Limited to premium paid

Limited to purchase price

Costs

High

Low to moderate

Low

Stock-specific?

Yes

Yes

No

Margin requirement

Yes

No (100% paid upfront)

No

Risks of Short Selling

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