Long puts are bought on the expectation that there is a good chance for the stock to go down in the short-term, allowing the investor a chance to profit from that directional outcome. The maximum upside occurs if the stock price drops to zero before expiry. The maximum loss on the other hand is limited to what is committed upfront – the option expires worthless should the stock price stay above the strike price before the expiry date.
Short selling on the other hand involves borrowing the shares and selling upfront. The expectation, similar to a long put, is to make a profit from the downward directional move of the concerned stock. The difference is that it is not time limited i.e., the position will stay intact until closed. The short sale proceeds are credited to one’s account – paying the dividends is one’s responsibility. The key downside is the unlimited potential loss - there is no theoretical limit to how high a stock can go and hence there is no limit to ‘how much’ one can lose, should the stock price march higher.
Long put positions can prove beneficial to value investors in the following situations:
- Say you own a stock XYZ at $30 per share. The price has since moved up to $50 and you still consider it a good value. However, the macro situation has changed and your analysis indicates the possibility for a sharp temporary pullback. In this scenario, buying protective long puts is a good strategy to earn additional income - should the stock drop, the puts increase in value.
- End of year tax considerations can lead to a situation where a stock might not be sold even though all analysis point to selling as the right strategy. Here also, buying long puts as part of a collar construction can ensure that profits are locked in.
- In situations when your fundamental analysis strongly indicates that a particular stock is way overvalued, committing a small amount of capital using long put positions is a good strategy to benefit from a probable pullback.
Short selling can be beneficial to value investors in the following situations:
- Some value investors attempt to construct a portfolio aimed at generating absolute returns – the purpose is to generate positive returns year after year, independent of overall market direction. A long-short approach is one way to arrive at such a portfolio – hold both long and short positions although on the average, one or the other sets of positions will be more, depending on the macro assessment. The aim is to profit from all directional moves the research indicates, rather than attempting to benefit only on the long-side.
- If the fundamental analysis of a particular stock has shown with a high degree of confidence that impending bad news (financials are questioned - fraud, SEC inquiries, pending lawsuits, etc.) will cause the company’s stock price to plummet, short selling such stocks is a good strategy to profit from the expected outcome. In such scenarios, you cannot predict the timing and so long puts are not a good option.