Betting on an Overheated Market: Shorts and Puts

Jul 19, 2007 by Adam C. Powell, Ph.D.

When the stock market begins to soar, sometimes people become interested in betting on a downturn. There are two ways that this can be done, which have substantially different risks associated with them.

Shorting a Stock

When you short a stock, you essentially sell the stock to another person at its current price, with the promise of delivering the shares to them at a later date. In the best case, the company has its share price drop to zero, and you make a profit of the value of the shares at the time you sold them short, minus the transaction fees. In the worst case, you short a company whose stock price goes way, way up. Imagine that you shorted one share of a stock when it was worth $100 per share, and it is now worth $1,000 due to some substantial growth. Well, you received $100 when you sold the short, but now owe a share worth $1,000. By selling this short, you have lost $900. With short sales, the upside potential is limited to the initial value of the shares sold short, but the downside potential is infinite!

In order to prevent people from losing infinite amounts of money, brokerages have margin requirements. People are required to hold excess cash in their account to pay for losses. Once the person runs out of margin, they are forced to settle the short by buying the stock. That way, the broker insures that the person sold the short is able to obtain the share.

 Buying a Put

A “put” is the ability to sell a stock at a given price. When you buy a put for a stock that you don’t own, you are considered to be buying a “naked put.” Why buy the right to sell stock you don’t own at a fixed price? If the price plunges, you can effectively buy the shares on the market, and then sell them at the price agreed to by the put, making a profit equal to the difference between the current share price, the strike price of the put, and the cost of the put. Puts are different than shorts in that they expire on a given date. As that date approaches, the value of a put declines. (Before a put expires, you can resell it if you like.)

So, imagine that a stock is trading at $100 per share, and you think it will go down. To take advantage of this, you decide to buy a put. The put has a strike price of $95. That means, it gives you the right to sell the stock at $95 per share. (Until the stock goes down, you would not want to use this right, as the market is letting you sell for $100 per share.) Since the person that sells you the put is taking on the risk that the stock will dip in price, and that they will be forced to buy it for more than it is worth, they charge you a fee for this risk, which is the price of the put. You can’t just buy one put, but must buy one or more contracts. A contract consists of puts on 100 shares. So, you buy contract costing $2/share, with a strike price of $95. To break even, the stock must go down to $93/share, as $93 = $95-2.

 What would happen if the stock went down to $90/share? You could buy up 100 shares, and use the put contract to resell them at $95/share. This right cost you $2/share. Thus, buying the put has made you $3/share! Since you own a contract that provides this right for 100 shares, $300 in profit have been made. As you never owned the underlying shares, only $200 was placed at risk to make the $300. This investment would have had a 150% return!

The problem with puts is that their value declines over time. If the put expires tomorrow, has a strike price of $95, and the stock price today is $200, it is unlikely that the put will ever be useful, and its resale value is close to zero. The value of a put is determined by the Black-Scholes equation, and declines as the stock moves higher above the strike price, and as the date of expiration approaches.