Long puts are bought on the
expectation that the stock has catalysts in place 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:
a)
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.
b)
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.
c)
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:
a)
Some value investors attempt to construct a portfolio
aimed at generating absolute returns – independent of the market direction, the
portfolio will generate positive returns year after year. 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.
b)
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.
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