Options Forum: Know Your Strategy

Would you please explain what the difference is between short-selling a call option and just buying the put option? -- M.C.

While both positions represent a bearish bet -- that is, they profit if the price of the underlying common stock declines -- they perform and produce very differently under the same set of circumstances.

Understanding the differences in cost, risk and price behavior of each position is crucial in determining which strategy best aligns with your predicted scenario. Do not confuse two similar bearish positions as being parallel, or replacements for each other -- a short call has a completely different profile than a long put.

The profit potential from selling a call is limited to the amount of premium sold, but the potential loss is unlimited. A long put option position has almost the inverse risk/reward profile: The maximum potential loss is limited to the cost of the option, while the profit potential is nearly unlimited. Only the fact that the price of the underlying stock cannot drop below zero prevents me from saying it is truly unlimited.

For example, let's assume XYX Corp. trades at $47.50 and one could buy the June $45 put for $1.50 a contract. The break-even, or effective, sale price is $43.50, 7.4% below the current $47 share price. If XYZ shares are above $45 on expiration, the option will be worthless and the position will realize the maximum loss of $1.50 a contract. Even a 5% decline in the stock price could result in a loss on the long put position. If XYZ declined below the $43.50 break-even point, the profits would increase as the stock declined.

By contrast, the strategy of selling the June $50 call short at $1.50 could realize its maximum profit of $1.50 even if XYZ shares increased to $50 per share. But if the shares tumbled to $40, the short call still would only earn $1.50 per contract while the put would be worth at least $5 per contract, or a 325% increase.

Selling the call short leaves a lot of money on the table. Therefore, selling calls might not be the best strategy on a stock that you think could suffer a precipitous decline.