Sometimes, we have a negative view on the market or a particular sector and want to "make a bet" against the market. This can be done by buying puts or selling short, either indices or specific securities. We may undertake such trades either as a way of profiting from a decline in price, or as a way of hedging an overall account. For example, a client may own a considerable number of European stocks, each of which individually we like. But if we are nervous about the outlook for European stock markets generally, we may hedge that position with an index put or short sale, instead of selling of the stocks.
In theory, buying a put is less risky than selling short, since the maximum loss from a put purchase is the price paid, whereas a short sale has, theoretically, unlimited loss potential. However, puts have two significant drawbacks: they are limited in time; and one pays a premium. In sum, puts are time-wasting assets.
Thus, if one buys a put on, say, Google, expecting the stock to decline, one must be correct, not only on the direction of Google (i.e., down), but right about the timing; the decline must occur during the period when the option is active. And the premiums on puts on some stocks, particularly the most overvalued and volatile ones, can be very high, making it difficult to make money from the purchase of puts. (This is one reason why we prefer to be sellers of options, rather than buyers; see discussion on Options.)
We short typically only in larger accounts. The client must have given us express authorization to sell short. The value of short sales will only ever be a small portion of a total account. Typically, we sell short listed stocks (that is, stocks listed on an exchange), where one can place an automatic buy back, should the stock move up. And we use those stops, which take the emotion out of what can otherwise be a hair-raising experience.
Having said all of that, shorting a stock, in essence, is no more than the reverse of buying it, and, although we do not aim to run a long-short program or hedge fund, shorting indices and individual stocks can be a useful hedge and a profitable exercise.
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