Buying puts makes more sense than shorting calls

ONE of the most important messages that warrant issuers have been trying to convey to the investing public over the past few years is that in order to profit in a falling market, it's better to buy put warrants rather than short-sell calls.

Indeed, such is the importance of this message that the Singapore Exchange last year issued a consultation paper on how best to deter short-selling of warrants, while in developed markets like Hong Kong, persistent short-selling can lead to a jail sentence.

From the viewpoint of issuers, short-selling messes up their inventories, distorts the figures and prevents them from making proper disclosures. This much is well-known and is the main reason for SGX's paper last year.

From the viewpoint of investors though, it also makes sense to buy puts instead of short-selling calls in a falling market. A simple numerical example should illustrate why.

Suppose that a stock trades for $1 and has a call warrant with an exercise price of 90 cents, which means the latter is described as '10 cents in-the-money'.

In the interest of simplicity, we'll assume that warrants always trade at their intrinsic values, which means this particular instrument is worth 10 cents ($1 - 90 cents).

Suppose that an investor who is bearish on the stock decides to profit from his view by short-selling this warrant. No matter how low the stock falls, the maximum amount the short-seller can make is 9.5 cents, and this is assuming he covers his position at the lowest possible warrant price of 0.5 cent.

Contrast this with the strategy of buying a put. For consistency, assume a put warrant that is also '10 cents in-the-money' exists on the same stock, which means this warrant has an exercise price of $1.10. Again, assume that like the call, the put trades at its intrinsic value, which is also 10 cents. Now suppose the stock drops to 80 cents and like the call, assume that all other factors are equal and time is not a problem.

The way puts work is that it is assumed that the put holder can, in theory, now buy the stock from the market at 80 cents and 'put' or sell it to the issuer for $1.10. If so, then his profit is 20 cents or $1.10 minus a total outlay of 90 cents (80 cents + 10 cents).

Of course in practice, the put holder does not actually exercise the warrant and simply sells the warrant in the market or if the warrant is held till expiry, receives a cash settlement from the issuer.

Whichever the case, the point is that the theoretical profit possible from buying a put is much higher than that from shorting a call - if the stock crashes to one cent, the put will be worth a whopping $1.09.

Furthermore, the shorting route incurs huge risk. If the stock does not fall as expected but instead surges upwards, the call seller can find himself suffering a theoretically unlimited loss.

The put buyer on the other hand, faces much less risk because if the warrant does not perform, his loss is simply limited to the amount paid for the put.

So why do some investors still insist on shorting calls? One possibility is that they perceive it to be somehow better psychologically to collect cash upfront from shorting a call than forking out cash to pay for buying a put.

Another is that some investors may still not be familiar with how puts work, or with the idea of buying something to make money in a falling market.

Fortunately, latest figures released yesterday by SG Securities show that the incidence of shorting is declining - bearish investors are now more likely to use puts instead.

Which, when you consider that the money to be made is so much better and the risks so much lower, should clearly be the preferred way.