How to Trade Options for Beginners: Covered Calls on thinkorswim® (YouTube link)
If you believe a stock price will decline, you can either:
- Short sell the stock, hoping to buy it back at a lower price.
- Buy a put option on the stock, giving you the right to sell the stock at a specific price if it declines.
Key Differences:
- Ownership: With short selling, you borrow the asset. With put options, you buy a contract.
- Leverage: Options often provide leverage, allowing investors to control a larger position with a smaller capital outlay compared to short selling.
- Time Decay: Option prices are influenced by time decay, meaning the option's value decreases as it approaches expiration.
Both strategies aim to profit from a declining stock price, but they carry different risk and reward profiles.
Short Selling: Betting on a Price Decline
Short selling is a trading strategy where an investor borrows a security (like a stock) and immediately sells it, hoping to buy it back later at a lower price. The difference between the selling and buying price is the profit if the price does indeed decline.
How Short Selling Works:
- Borrowing the Security: An investor borrows shares of a stock from a broker. Short sellers pay interest on the borrowed shares and are liable for any dividends paid during the short position.
- Selling the Shares: The borrowed shares are sold on the open market immediately.
- Covering the Position: If the stock price falls, the investor buys back the same number of shares to return to the lender. The difference in price is the profit.
The Risks of Short Selling
Short selling comes with four main risks:
- Limitless losses: Unlike buying shares (which has a capped loss equal to your investment), shorting a stock has no upper limit on potential losses. If the stock price rises unexpectedly, you may have to pay significantly more to replace the borrowed shares.
- Fluctuating borrowing costs: The interest rate to borrow a stock can change rapidly based on supply and demand. Sudden fee increases can make it impractical to maintain a short position. Keep these factors in mind when considering short selling!
- Dividends: Short sellers owe dividends on borrowed shares. To avoid this, they often close positions before the ex-dividend date.
- Margin calls: Short selling often requires a margin account, meaning the investor needs to deposit a certain amount of money as collateral. If collateral falls below a certain level, brokers demand additional funds or securities.
Put Options: The Options Equivalent to Short Selling
Put options are financial contracts that give the holder the right, but not the obligation, to sell an underlying asset at a specified price (strike price) on or before a specific date (expiration date).
How Put Options Mimic Short Selling:
- Profit from Price Decline: Similar to short selling, put options profit when the underlying asset's price decreases.
- Limited Risk: Unlike short selling, where potential losses are theoretically unlimited, the maximum loss on a put option is the premium paid for the contract.
Steps to Buy a Put Option:
- Open a Brokerage Account: Ensure it allows options trading.
- Understand Put Options: Learn about strike price, expiration date, and premium.
- Choose an Underlying Asset: Select the stock or index for the put option.
- Select Strike Price and Expiration Date: Decide on these details for your option.
- Place the Order: Submit a market or limit order to purchase the desired number of put contracts.
- Monitor the Option: Track the option's price and the underlying asset's price.
- Exercise or Sell the Option: Decide whether to exercise the option if it becomes profitable or sell it before expiration.
Steps to Exercise a Put Option:
- Contact Your Broker: Inform your broker of your decision to exercise the put option.
- Pay the Strike Price: You'll need to pay the strike price for the shares you're obligated to buy under the option contract.
- Receive the Shares: Your broker will deliver the shares to you.
- Sell the Shares: Since the market price is lower than the strike price, you can sell the shares at the current market price, realizing a profit.
Important Note: Exercising a put option is generally not the most efficient way to profit from it. Often, it's more beneficial to sell the option itself before expiration, especially if the option's time value is significant.
Other Strategies for Profiting from a Decline
While short selling and put options are the most direct ways to profit from a declining market, there are other strategies that can achieve similar outcomes:
Inverse ETFs
- Inverse ETFs aim to deliver the opposite returns of an underlying index. If the market declines, an inverse ETF will typically rise.
- Example: A 2x inverse S&P 500 ETF would aim to double the inverse performance of the S&P 500.
Bearish Spread Options
- Bearish spread options involve creating a position that profits from a decline in the underlying asset's price while limiting potential losses.
- Examples: Put spreads, call spreads, and straddles can be structured to benefit from a downward market.
Pairs Trading
- Pairs trading involves identifying two correlated stocks and betting on their price relationship to revert to the mean. If one stock outperforms the other, a trader might short the outperforming stock and long the underperforming one.
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