Question

You’ve decided that Company ABC is a poorly run company and that the price of the company’s stock is likely to decline over time. If you wish to invest so as to take advantage of this view, explain the relative advantages and disadvantages of shorting shares of stock versus buying a put option on the stock.

Answer 1

Short selling- When you expect the price of the share will come down in the few days, you adopt this strategy, in this strategy, You sell the shares of the company that you do not have, at higher price and when the share price comes down, you buy it back to offset your position, the difference between selling and buying is your profit.

Advantage- This is a very easy strategy and gives you higher profit if the stock goes down. There is no minimum number of shares that you need to sell, you can sell 1 share or 100 as per you wish and risk taking capacity.

Disadvantage- This is a risky strategy as if the stock price will go up, you will suffer huge loss, this strategy comes with unlimited loss. This strategy needs higher initial and maintenance margin.

Buying a Put- Put is an option that is a derivative contract, it is a right but not the obligation to sell an underlying at a specified price. Put is bought when trader is bearish towards a particular security or overall market. When stock goes down, Put price increases and gives you profit.

Advantage- This is a limited risk strategy, trader's maximum loss is the premium that he pays to buy the Put. In this strategy the profit is unlimited.

Disadvantage- Options are risky and require in depth knowledge, trader has to pay premium, options lose their value very soon, premium keeps on coming down as the expiry comes nearer. One contract or lot size of Put options contains 100 shares or some quantity of shares that you have to buy if you are buying single contract/lot.