I'm still trying to figure out, why, if a speculator believes a security will go down in value they use the traditional route of short-selling, when it would seem that purchasing put options is the less risky method.
The potential losses for a short seller of stock are almost unbounded whereas a buyer of put options is only liable to the amount he has purchased in put options.
Is the problem that options markets do not have the liquidity to handle any meaningful amounts?
Short sales have a lower direct cost (i.e., the price of the put option), and so also a higher potential profit, but a much higher risk. Unhedged short sales are incredibly risky, of course, but they're typically hedged in one fashion or another. Put options are fairly expensive, so they won't necessarily be profitable unless the stock depreciates significantly, while a short sale will be profitable if it even drops only a little (if you disregard the opportunity cost of the margin requirement).
Investopedia has a great realistic example of the difference. The cost of the put option in their example was about 20% of the potential profit - i.e., the profit if TSLA were to drop to zero - meaning TSLA would have to drop quite a lot (20%) for the put option to be in the money. That's what you're exchanging; put options basically are insurance on short sales, but often very expensive insurance.
Yes, the potential loss for a short seller of stock is almost unbounded but no stock has ever gone to infinity. Anyone with any experience with shorting would practice disciplined risk management should a short position move against him. Yes, a gap can hurt but no trader with a lick of sense doesn't cut losses.
As for long puts versus short stock, there are advantages and disadvantages for each:
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SHORT STOCK
Requires requires 50% margin overnight (US) but only 25% intraday for a Pattern Day Trader.
Stocks aren't always borrowable. If they are, the borrow cost may be next to nothing or it can be significant.
The delta of stock is 100 so without margin, it's a dollar for dollar gain or loss as the security moves. Margin leverage just multiplies the P&L in either direction.
The Alternative Uptick Rule is triggered when a stock experiences a price decline of at least 10% in one day. That may hinder your ability to open or add to a short position.
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LONG PUTS
They must be paid for in full. The most that you can lose is the cost of the option.
They are a wasting asset so time decay (theta) erodes your position. Your window of opportunity is limited by expiration.
They can inflate in value if implied volatility expands and can lose value if it contracts (vega), regardless of share price.
Option B/A spreads tend to be wider than for equities, particularly for deep ITM options.
Pending dividends inflate the cost of a put and must be factored into option strategies calculations.
Liquidity? The options of some stocks trade by appointment (low Open Interest :-). Or it could be 10's of thousands of contracts a day in certain strikes if it's the widely traded SPY.
Options have a delta of zero to 100.
Deep ITM puts with a delta of 100 mimic the stock and P&L will be 1:1 to the downside but the loss ratio will decrease as the price of the security rises and the put's delta decreases.
ATM puts have a delta of about 50 so on a 1:1 basis, initially you'll make 50 cents on the dollar as the security drops.
OTM puts have a lower delta so they will appreciate fractionally but they offer greater leverage due to their low cost. Sort of like betting on the long shot horse at the track. If there is a volatility smile (skew), OTM puts be more expensive relative to closer to the money puts (not important if you get a big move in the underlying).
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Which one is better involves one's experience, risk tolerance, time frame and discipline. In general, I'd say that shorting a security is more effective for short-term trades whereas a put may not respond much to intraday price movements (depends on the delta).
For longer time periods and for the less experienced and less disciplined, buy puts, despite all of its warts ;-)
Also, not every share has Puts around, and not always for the target values you want.
Plus, you need to find someone that buys them the moment you want to cash in. With shorted shares you can buy back the much more liquid shares much easier.
