stock or stock index declines.
Buying puts gives the investor upside potential if the price of the
underlying declines. The upside potential is reduced by the option price;
in exchange for the reduced upside potential due to the cost of purchasing
the put option, the loss is limited to the option price. Thus, in comparison
to short selling in the cash market by borrowing the stock, an
investor who buys puts will realize a lower profit due to the option price
if the price of the underlying declines. Effectively, the difference in profit
when the price of the underlying declines is less than the option price
due to the cost of borrowing the stock. In contrast to short selling in the
cash market by borrowing the stock, the loss is limited to the option
price if the price of the underlying increases.
In addition, buying a put option offers an investor leverage. This is
because for a given amount that the investor is prepared to invest in a
short selling strategy, greater exposure can be obtained. Of course, the
greater profit potential by using the leverage provided by buying puts
means that there is greater potential loss.
Now let’s look at selling calls in comparison to selling short in the
cash market by borrowing the stock. The profit from selling calls if the
price of the underlying declines is limited to the option price received,
regardless of how much the price of the underlying declines. However,
there is no protection if the price of the underlying increases. In comparison
to short selling in the cash market by borrowing the stock, selling
calls has limited profit potential if the price of the underlying declines.
The loss should the price of the underlying increase is less for the call
selling strategy because of the option price received. That is, selling calls
and short selling in the cash market have substantial downside risk but
the amount of the loss in the case of selling calls is reduced by the
option price received.
Read More : Short Selling and Basic Option Strategies
