Sometimes, investors feel that a stock or asset will go down instead of up, and this bearish trading thesis is usually reflected by short selling stocks and creating put options. Although both of these investments are betting that the market will go down, their fundamental mechanics and risk profiles are very different. Think something is on the downward slide and want to bet on it through investment? You’ve come to the right place, and you don’t need a quantum computer handy to do the calculations by yourself. Below, we will take you through what short selling and put options are, and how to utilize them for trading.
What is short selling?
Short selling is a trading strategy where you sell shares you don’t own, aiming to buy them back later at a lower price. To do this, you borrow the shares, typically from your broker, sell them on the open market, and then repurchase and return them once the price drops. The profit comes from the difference between your sale price and repurchase price, assuming the stock moves in your favor.
The mechanics of this are pretty simple, right, but the risk is substantial. Your potential gains are limited (a stock can only fall to zero), but you could theoretically experience unlimited losses if the stock does indeed continue to rise. This can be even more pronounced if you are short selling using leverage ie, using debt to magnify your position. Short selling demands precision, strong risk controls, and constant monitoring, because in fast-moving markets, one surprise catalyst can turn a calculated bet into a costly margin call. Below are the steps to short selling, how they work, and what their purpose is.
| Step | Action | What it means |
|---|---|---|
| Borrow shares | You borrow shares from your broker | Shares are typically sourced from the broker’s inventory or other clients. You’re temporarily “renting” them, often for a fee. |
| Sell shares | You sell the borrowed shares on the open market | You receive cash from the sale, but still owe the broker those shares. |
| Wait for price drop | You monitor the market and wait for the stock to fall | If the price declines as expected, you prepare to buy the shares back at a lower cost. |
| Buy to cover | You repurchase the shares and return them to the broker | Your profit is the difference between the sale and repurchase price, minus any borrow fees and trading costs. |
Here’s how it works, step by step:
- You borrow shares from your broker: These are typically lent from the broker’s inventory or from another client’s holdings. You don’t own the shares, you’re temporarily “renting” them, often with a fee.
- You sell the borrowed shares on the open market at the current price. This puts cash in your account, but you still owe the broker those shares.
- You wait for the price to drop: If the stock declines as expected, you can buy the same number of shares back at the lower price.
- You return the shares to the broker, completing the short sale: The difference between your sale price and buyback price, minus fees and interest on the borrow, is your profit.
What if the stock goes up instead?
If the stock ends up increasing instead of falling, you can get into trouble. You are still obligated to buy it back, no matter how high the price goes. This means, in theory, you could suffer from unlimited losses if the stock continues to climb with no end in sight. Because short selling is done on margin, your broker may demand additional collateral if the trade moves against you. A sudden spike can trigger a margin call or even forced liquidation, locking in steep losses.
Example
You short 100 shares of XYZ at $50, generating $5,000 in proceeds. If the stock drops to $40, you buy back for $4,000 and make a $1,000 profit. But if it surges to $70, buying back costs $7,000, leaving you with a $2,000 loss on a $5,000 trade. That’s a 40% capital hit, and if the stock keeps rising, the losses can spiral; this is why short selling carries theoretically infinite risk.
| Scenario | Stock Price | Action Taken | Cash Flow | Profit / Loss |
|---|---|---|---|---|
| Initial short sale | $50 | Sell 100 borrowed shares | + $5,000 | – |
| Stock drops | $40 | Buy back 100 shares | – $4,000 | + $1,000 |
| Stock rises | $70 | Buy back 100 shares | – $7,000 | – $2,000 |
Risks and additional implications
Short selling can be lucrative, but it’s also one of the riskiest strategies in the market. Your downside is theoretically unlimited, there’s no ceiling on how high a stock can climb, and if it moves against you sharply, losses can escalate fast. Because you’re using margin, most brokers require 150–200% collateral, meaning you might need $7,500 to $10,000 in your account just to short $5,000 worth of stock. If your position deteriorates, mark-to-market rules can trigger margin calls, forcing you to add funds or close the trade at a loss.
You’ll also pay borrowing fees, which can be steep if the stock is hard to locate or popular among short sellers. And in thinly traded or volatile names, you risk forced covering, where your broker closes your position without your input. Worst of all, a short squeeze, driven by coordinated or panic buying, can send prices surging, pushing you to exit at severely elevated levels.
Bottom line: timing matters, risk controls are essential, and short selling isn’t suited for undercapitalized or passive traders.
What is a put option?
A put option is a financial contract that gives you the right, but not the obligation, to sell a stock at a set price (the strike) before a specific expiration date. Options in general are essentially bets either way that the price will move one way or the other, and for this, you pay what’s called a ‘premium’. In the case of put options, when the stock drops below your strike, the value of the put rises, allowing you to either sell the option at a profit or exercise it to sell shares above market value.
Unlike short selling, which carries unlimited risk, put options offer defined risk and leveraged downside exposure. Your losses are capped at the premium paid, while gains increase as the stock declines. That’s why puts are widely used for both hedging long positions and making directional bets, especially when you want downside protection without opening a margin account or borrowing shares. Below are the steps to short selling, how they work, and what their purpose is.
| Step | Action | What it means |
|---|---|---|
| Buy a put contract | Select the strike price and expiration | You now hold the right to sell at that price before the contract expires. |
| Pay the premium | Upfront payment (e.g., $3/share) | This is your max possible loss per share; no margin required! |
| Monitor the market | Stock falls below the strike price | The option’s value increases; you can sell it or exercise it for profit. |
| Exit the trade | Sell or exercise the put before expiration | You collect profits based on the difference between the strike and market, minus the premium paid. |
What if the stock doesn’t drop?
If the stock stays above your strike, or rises, your put loses value. Once it expires, it becomes worthless, and your loss is limited to the premium paid. While disappointing, it’s far less damaging than a margin-driven loss from a short squeeze.
Example
XYZ Corp is trading at $50. You buy one put option with a $50 strike and one-month expiration for $3 per share ($300 total). A week later, the stock drops to $40. The put is now worth $10 per share. You sell it for $1,000, netting a $700 profit after the premium. That’s a 230% return, while risking only your initial $300.
| Scenario | Action Taken | Stock Price | Cash Flow | Profit / Loss |
|---|---|---|---|---|
| Buy put option | Buy 1 put @ $50 strike | $50 | – $300 (premium) | – $300 |
| Stock drops | Put value rises to $10/share | $40 | + $1,000 (sell put) | + $700 |
| Stock rises or stays flat | Put expires worthless | $50+ | – | – $300 |
Risks and trade-offs
Put options limit downside but come with time and volatility sensitivity. As expiration approaches, time decay accelerates, especially if the stock price doesn’t move. If implied volatility drops, your option may lose value even if the stock trends in the right direction. And in thinly traded markets, low liquidity can mean wide bid-ask spreads that eat into your returns.
Used properly, puts are a flexible way to hedge or speculate with known risk, but success depends on understanding how timing, strike selection, and market conditions affect your payoff.
The main differences between short selling and put options
As explained above, put options and short selling are indeed different. The main differences between short selling and put options listed below
| Factor | Short Selling | Put Options |
|---|---|---|
| Capital requirements | Requires a margin account and significant collateral | Only upfront premium required |
| Risk profile | Unlimited loss potential if stock price rises | Loss capped at premium paid |
| Time sensitivity | No expiration but margin calls possible | Expires and loses value over time |
| Profit potential | Upside capped at 100% | Greater upside if stock drops past strike |
| Borrow dependency | Must locate and borrow shares | No borrowing needed |
| Liquidity factors | Depends on stock’s trading volume and float | Depends on option chain, strike, and expiry |
Choosing the right strategy: When to use short selling vs. puts
Both short selling and put options can profit from a falling market, but the right choice depends on your goals, risk tolerance, and timing. Here’s how to decide which strategy fits best based on your market view and trading style.
| Scenario | Short Selling | Put Options |
|---|---|---|
| Best for | Active traders (intraday or swing) | Defined-risk trades or portfolio hedging |
| When to use |
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What professionals consider key lessons from real trades
Professional traders don’t just choose between puts or shorts based on instinct, they match each strategy to their structure, tax profile, and trading objectives. Hedge funds, for example, often use puts to hedge long positions or play volatility setups without taking on unlimited risk. Many also prefer puts when shorting high-beta or gamma-sensitive names, especially going into earnings or macro events. On the other hand, proprietary trading firms or quant desks may lean toward short selling for its immediacy and precision, especially in high-frequency environments where option liquidity may lag.
Tax treatment also plays a role. Short selling typically triggers short-term capital gains, which are taxed at higher rates. In contrast, put options held to expiration can sometimes receive more favorable treatment depending on duration, tax status, and the trader’s classification (retail vs. professional).
Pro-level strategies vs. common trader mistakes
Professionals use layered strategies to limit risk and maximize returns, whereas novice traders who might not have the requisite experience will make mistakes. Below is a breakdown of how experts and seasoned traders strategize the downside and some of the mistakes that newbies should avoid.
| Advanced Strategies Used by Pros | Common Pitfalls to Avoid for Novices |
|---|---|
| Synthetic short position: Long put + short call at the same strike mimics short selling without borrowing shares. | Overleveraging on margin: One squeeze can erase capital if position sizing isn’t controlled. |
| Protective put: Long stock + long put hedges downside, commonly used in institutional portfolios. | Ignoring implied volatility: High IV inflates option costs. Falling IV can reduce profits—even on correct directional moves. |
| Put spreads: Buy a higher-strike put and sell a lower-strike put to cap costs while targeting downside movement. | No exit plan: Without a clear strategy, both shorts and puts can backfire quickly. |
| Rolling positions: Pros often roll options to extend duration or adjust strikes, managing time decay and maximizing edge. | Neglecting liquidity: Wide spreads or hard-to-borrow stocks can result in poor fills or forced exits. |
Case study: GameStop 2021 – when risk control broke down
No modern trade illustrates the dangers of unchecked short exposure like the GameStop (GME) short squeeze in early 2021. What began as a low-volume, heavily shorted retail stock exploded into a Wall Street crisis when coordinated buying on Reddit’s WallStreetBets pushed GME from under $20 to over $400 in a matter of days.
Hedge funds like Melvin Capital faced massive margin calls and were forced to unwind positions at eye-watering losses. Many short sellers were caught flat-footed, underestimating social momentum and liquidity risks. Meanwhile, some put option holders, who had capped their downside and benefited from spiking implied volatility, closed their positions with massive gains, even before the stock peaked.
Final thoughts: Bearish positions require different risk
Sometimes, you can make money when the market declines, but that usually involves some risk. The risk you are willing to take depends on a number of factors, but remember, short selling has the specter of unlimited losses hanging over it, which will scare even the most pro-risk traders. Short selling and put options are powerful tools in a trader’s arsenal for profiting from declining markets. While both strategies aim to capitalize on downward price movements, they differ significantly in mechanics, risk profiles, and suitability for various trading scenarios. Short selling offers direct exposure but comes with unlimited risk and margin requirements, making it more suitable for experienced traders. Put options, on the other hand, provide a defined-risk approach, ideal for those seeking to hedge positions or engage in speculative plays with limited downside. Understanding the nuances of each strategy, including their risks, costs, and appropriate use cases, is essential for effective implementation and risk management.
FAQ
What are the tax implications of short selling and buying put options?
Short selling typically results in short-term capital gains, taxed at ordinary income rates, regardless of the holding period. Buying put options can lead to either short-term or long-term capital gains, depending on how long you hold the contract and whether it’s exercised or sold. Tax treatment can vary, so it’s wise to consult a financial advisor or tax professional.
How does liquidity affect the execution of short selling and put options?
Liquidity is critical for both strategies. In short selling, thinly traded stocks may be difficult to borrow or close without causing large price swings. For put options, low liquidity in the option chain can lead to wide bid-ask spreads and poor execution. Traders should always assess volume and open interest before entering a position.
Can I use both short selling and put options simultaneously?
Yes, advanced traders often combine the two to manage exposure. For example, a trader might short sell a stock and simultaneously purchase a put option as a hedge. This limits the upside risk of the short in case the stock rallies unexpectedly. However, combining strategies requires precise timing and careful capital allocation.
Benjamin writes about finance, real estate, business, economics and most things business or investment related, for publications such as The Motley Fool, SuperMoney, and Joy Wallet. Hailing from Denver, Colorado, he spent 15 years in East Asia heavily involved in both the financial services and real estate industries. He enjoys writing about all the interesting ways this great spinning ball that we call earth works; particularly when it comes to the intersection of business, trade, finance, and history. Read Full Bio
