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What are the advantages of buying a put option rather than short selling a stock?

First of all, options are simply contracts between two parties that give one party the right, but not the obligation, to buy or sell a particular asset at a set price, known as the exercise or strike price, on or before a certain date. That date is known as the expiration date.

A put option is a contract which gives its buyer the right to sell an asset, such as a stock. The other party, the option seller or writer, receives a payment, called a premium, and is obligated to buy the stock if the buyer exercises the option.

Short selling is selling a security -- in this case a stock -- which the seller does not own. The short seller believes the stock's price is going to fall, in which case the seller will be able to cover the sale by buying the stock back at a lower price. The profit is the difference between the initial selling price and the subsequent purchase price.

Short sellers and buyers of put options attempt to profit from an anticipated fall in the stock's price.

Four advantages to buying put options rather than short selling a stock:

1. Put holders face a risk that is limited to the initial cost of the put. Short sellers, though, face potentially unlimited losses since, in theory, there's no upper limit on a stock's price, and therefore the price at which a short seller may have to cover the sale by buying the stock back;

2. Options are paid for when you buy them; short-sellers must maintain adequate margin and therefore may be required to deposit more money if stock's price rises;

3. Put holders aren't liable for any dividends paid by the stock - short sellers are;

4. Put options almost always offer potentially higher percentage returns because you generally pay a smaller fraction of the underlying stock's value than you do shorting stock.

The main disadvantage of buying a put option is the fact they have a limited life. A short position could be held for an infinite period, in theory. As well, a put option exposes you to potentially greater percentage losses.

Example:

Assume XYZ Co. is trading at $50 a share and we are trying to decide between short selling 100 shares or buying one XYZ June 50 put option. (Each equity option covers 100 shares). XYZ June 50 refers to a put option with a June expiration and a $50 exercise price. The put is trading at $2.50 per share. If we sell short 100 shares we will have to deposit $1,500 margin into our margin account (on top of the $5,000 received from selling the shares). If we buy the put, we have to deposit $250 (cost of the option) into our account. Now assume the stock falls to $40 and the option's price increases to $10 per share. If we cover our short position, which will cost $4,000, we will earn a $1,000 profit, a return of 66.7%. If we sell our put at $10, we'll earn a $7.50 per share profit - a return of 300%. Assume the stock's price instead rises to $60 and the price of the option falls to 10 cents per share. If we cover our short position, which will cost $6,000, we will lose $1,000 for a return of minus 66.7%. If we sell our put at .10 per share, we will lose $240 for a return of minus 96%. In actual dollars, our maximum loss on the put is limited to our initial investment, whereas our maximum loss on the short sale is without limit, theortically.