The debate of short selling versus put options is as old as the hills. There is no difference between short selling and put options buying as they both involve a negative view on a stock or the index. Let us first understand the basic difference between buying a put option and selling futures on the stock.
Buying put options versus selling futures on the stock..
Let us assume that you expect the stock price of Tata steel to fall from Rs.720 to Rs.600. That is a sharp correction of over 16% and as a trader you can surely play the stock through the derivatives market. There are two ways to play it. You can either sell futures of Tata Steel in the current month or the next month contract. Alternatively, you can buy put options of a suitable strike. But, that is not the challenge. The real challenge is when you should play this downside in the stock using put options and when you should sell futures. In this short selling versus put options debate, there are 5 key considerations:
1. Are you looking at the very short term or the long term?
If you are looking at a very short period of time then typically futures will work better. That is because futures move in tandem with the stock price. Put options, on the other hand, have a time value component and an intrinsic value component to it. Options prices, especially out of the money options may not be too sensitive to price movements in the short term. Hence if you are looking at a quick movement in the stock price then selling futures would be an ideal option.
2. Do you have constraints on paying margins?
This is an important question. When you sell futures there is an initial margin that will have to be paid. Plus, you will have to pay MTM margins if the price movement is temporarily against you. In case you are not keen to pay these margins then you can go for a put option. In case of put option you only pay the option premium and then do not have to worry about MTM. That is a common reason for traders to opt for put options over futures.
3. Are you playing time value or are you playing the stock price?
This is an important question to answer. If you are expecting that the time value of the option will go up due to a sharp rise in volatility in the market, then buying put options may be a better choice. You cannot sell futures to play a rise in volatility. You can actually buy deep out of the money put options and play the rise in volatility instead of just focusing on the price movement. Options prices are directly correlated to the level of volatility, irrespective of the stock price movement.
4. Are you looking at substantial leverage in the market?
What if you are extremely confident or have a very high conviction that the stock of Tata Steel will actually fall by 16% in 1 month? When it comes to selling futures there will be a limit to your leverage. Remember, initial margins and MTM margins can add up to quite a bit. Thus there is a limit to the level of leverage that you can afford. In case of put options you can take a risk and go deeper out of the money and add on to your leverage. The advantage is that your total risk will still be limited by the amount of premium paid.
5. When you are expecting a breakout but are not sure of the direction..
This is a normal quandary ahead of the Infosys results. Typically, Infy has been volatile around its results but the direction of this volatility has been quite mixed. You are better off playing this kind of an uncertain situation using options instead of futures. Futures really do not allow you to play uncertain volatility. The beauty of options is that you can creatively combine these options and create non-directional strategies. Without getting into options trading strategies for beginners, the crux of the matter is that options will work better when you want greater flexibility and are looking at non-directional strategies.
In the debate on short selling versus put options it ultimately boils down to the unique nature of the situation. There are key differences between short selling and put options and their application will depend on the volatility, your time frame and your margin paying capacity.