Choosing Between Puts, Calls, and Short Selling: A Comprehensive Guide

When it comes to trading in the financial markets, investors are often faced with the decision to buy puts, sell calls, or short sell. Each strategy comes with its own unique benefits and risks, making it important to understand the nuances before making a decision. This guide will help you determine which option is most suitable based on your trading goals, risk tolerance, and investment horizon.

Understanding Puts

Puts are options contracts that give the buyer the right but not the obligation to sell an underlying asset at a specified price within a certain time frame. When considering buying puts, several factors come into play, including the strike spread, liquidity of the asset, and delta values.

Buying puts is a good choice when:

The strike spread between bid and offer is around 1-2 cents, indicating a favorable price. The asset has adequate volume at the bid and offer, ensuring the liquidity needed for your position. The trade is positioned either at-the-money (ATM) or deep in the money (ITM) based on the market liquidity at the strike levels. The delta value, which measures the change in the option price relative to the underlying asset, is in the 60 or higher range, suggesting higher volatility and potential for profit.

One of the advantages of buying puts is the known risk factor. The maximum loss is limited to the initial premium paid, making it a relatively safe choice for managing downside risk.

Choosing to Sell Calls

Selling calls involves the seller receiving a premium in exchange for the obligation to sell the underlying asset at a specified strike price if the option is exercised. Selling calls can be a viable strategy, especially if you are covered, meaning you own the underlying asset to fulfill the obligation.

However, selling naked calls (without owning the underlying asset) can be extremely risky. Without a hedge, the seller's potential loss is unlimited, as the stock price can theoretically rise indefinitely. Expert traders like James Cordier have experienced financial ruin due to their naked call positions. If you decide to sell calls, ensure you have a long-term, smoothly trending equity position, as rapid drawdowns can be detrimental.

In some cases, selling calls can be beneficial in reducing the overall cost basis of a long-term position. The premium received from selling the calls can offset some of the expenses associated with holding the asset, thereby reducing the net cost.

Opting for Short Selling

Short selling involves borrowing an asset, selling it, and then buying it back later. This strategy is one of the most straightforward but also poses the greatest risk. Shorting is particularly dangerous because there is no upper limit to the potential loss.

While futures and forex contracts can mitigate overnight risk by allowing almost 24-hour trading, stocks and ETFs are subject to overnight short squeezes, where the price of the stock can surge unexpectedly, leading to significant losses.

Short sellers should always have a defensible reason for shorting, such as high economic uncertainty or impeccable understanding of microeconomic factors.

When to Not Use These Strategies

Given the complexity and risks involved, it is often recommended that ordinary investors refrain from using puts, calls, or short selling as primary trading tools. These instruments can lead to massive losses and may not align with the typical investment goals of the average trader.

Regular investors should primarily focus on long-term growth strategies or hedging through established fund managers and financial advisors. Engaging in such complex trading activities without proper planning and risk assessment can be financially detrimental.

If you are in doubt or unsure about any of these strategies, consult with a financial advisor or conduct thorough research before proceeding.

Key Takeaways:

Buying puts offers limited risk and is suitable for those looking to hedge against potential declines in the market. Selling calls can be a profitable strategy if done with a covered position, but it carries significant risk without a protective hedge. Short selling is the most risky but can be used to profit from a decline in the market, albeit with potential for unlimited losses. For average investors, these strategies may not align with their goals and can lead to financial ruin.

By carefully considering your goals, risk tolerance, and market conditions, you can make an informed decision on which trading strategy is best for you. Whether you choose to buy puts, sell calls, or engage in short selling, it is crucial to understand the risks involved.