Short Selling Vs. Put Options: How Payoffs Differ

Purchasing a put option and entering into a short sale transaction are the two most common ways for traders to profit when the price of an underlying asset decreases, but the payoffs are quite different. Even though both of these instruments appreciate in value when the price of the underlying asset decreases, the amount of loss and pain incurred by the holder of each position when the price of the underlying asset increases is drastically different. This is because one transaction obligates the trader to perform a specific action and the other transaction gives the trader the right to do so. 

A short sale transaction consists of borrowing shares from a broker and selling them on the market in the hope that the share price will decrease and you'll be able to buy them back at a lower price. As you can see from the diagram below, a trader who has a short position in a stock will be severely affected by a large price increase because the losses grow as the price of the underlying asset increases. (See also: Short Selling Tutorial.)

The reason why the short seller sustains such large losses is that they have to return the borrowed shares to the lender at some point, and when that happens, the short seller is obligated to buy the asset at the market price, which is currently higher than where the short seller initially sold. The danger to the trader comes from not determining and sticking to an exit strategy when the trade starts to go south and holding the position far longer than he should to mitigate the loss.

In contrast, the purchase of a put option allows an investor to benefit from a decrease in the price of the underlying asset, while also limiting the amount of loss they may sustain. The purchaser of a put option will pay a premium to have the right, but not the obligation, to sell a specific number of shares at an agreed upon strike price. If the price rises dramatically, the purchaser of the put option can choose to do nothing and just lose the premium. This limited amount of loss is the factor that can be very appealing to novice traders. (See also: Options Basics Tutorial.)