When you short sell a stock, you borrow it from your broker, sell it to someone else, and hope to buy it back later at a lower price. Your profit comes from the difference between the price for which you sell the stock and how much you pay to buy it back.
For example, suppose stock XYZ is trading at $50 a share. Let's say you think it's overvalued and is going to fall. You log into your brokerage account and sell to open 100 shares of XYZ. Someone pays you $5,000 for the shares. Soon thereafter, the stock falls to $42 a share. You cover your short position by buying to close 100 shares of XYZ at $42. Since you originally received $5,000 and now paid $4,200, you made an $800 profit. (Had the shorted stock paid dividends while you borrowed it, you'd pay out those dividends, so your profit might be a little less. I'm excluding commissions. You need a margin account to sell short.)
There are various risks in short selling. Here are two important ones.
1. While your potential profits are limited (in the example above, the most you can make is $5,000--if XYZ goes to $0 a share) your potential losses are theoretically unlimited. Suppose you're wrong about XYZ or people are stupid and keep buying shares, and the stock keeps going up. You may lose far more than you bargained for when you (or your broker) close your position. Say XYZ goes to $100 a share. You're now down $5,000. If you don't have that extra cash in your account, your broker's going to demand money.
2. Related to this is the short squeeze. Let's say you're not the only one who thinks XYZ is going down. A bunch of other people short it too. Suppose some positive news comes out and people start buying XYZ. Those who have shorted XYZ will scramble to close their positions, driving demand up, and the stock will go even higher as a result.
There are other problems with short selling. Sometimes you just can't do it. Your broker might not have any shares for you to borrow, or some silly government regulation may get in the way.
There are two ways to mitigate the above risks and go around these potential problems. Both involve going long--buying instead of short selling.
Let's say you think XYZ's price fall because its sector will go down. Or suppose you think XYZ will fall because the entire market will drop. You can buy an inverse or bear market ETF either for a sector or for a broad index, which I wrote about here, and provided a list of here. In buying an inverse ETF, you're going long. There's no margin involved (unless you want to buy on margin). You're not borrowing anything. The most you can lose is the amount of money you put in.
But let's say you think XYZ is going down because it's overvalued, and you have no idea about its sector or the market in general. Inverse ETFs are too broad. Not to worry, you can buy puts on XYZ and profit from its fall.
A put option is a contract between two parties, a buyer and a writer, on an underlying asset (a car, a painting, 100 shares of stock, etc). The buyer of a put has the right to sell the writer of the put the underlying asset at a certain price by a certain date.
Suppose I have a car worth $20,000 that I'm thinking of selling within the next two years, but I'm worried that its value will decline. Someone (call him Bob) is interested in buying the car, and he thinks the its value will probably stay the same or rise. To protect the sale value of my car, I enter into a contract with Bob. I'll pay him $1,000 in exchange for the right, but not the obligation, to sell him the car for $20,000 within the next two years. This is an example of a put option. I'm the buyer and Bob is the writer of the contract.
Let's say a year passes, and the market price for the car is now $15,000. I think it'll go lower still, so I sell the car to Bob for $20,000, as is my right by contract. While the car's value dropped by $5,000, I've only lost the $1,000 I originally paid Bob.
On the other hand, suppose that almost two years after the contract is signed the car appreciates in value. Suppose its now worth $23,000. I decide not to sell the car to Bob, as is my right by contract. I can sell the car to someone else for $23,000. Since I paid Bob $1,000, I've gained $2,000 on my car's appreciation (current worth of $23,000 less $1,000 paid to Bob less car's value when contract was signed).
Let's add a wrinkle to this example. Suppose the car doesn't belong to me, but to a car dealer. Suppose also that the car dealer is always willing to sell the car at the current market value. I enter into the same contract with Bob as outlined above (option to sell car to him for $20,000 within the next 2 years, in return for $1,000 paid to Bob).
Suppose again that the car's value drops to $15,000 within two years. I can buy the car from the dealer for $15,000 and then sell it to Bob for $20,000. Since I previously paid Bob $1,000, I make $4,000 in profit ($20,000 contract price to Bob less $15,000 paid for the car less $1,000 paid to Bob for contract). That's four times my original investment. Talk about leverage.
But suppose the dealer's car goes up in value and is now worth $25,000. I don't do anything. I've lost the $1,000 I paid Bob, but that's it.
The first example, where the car is mine, is akin to selling puts on stocks you own. This is insurance. The second example, with the dealer's car, is closer to put options on stocks you don't own. There's another wrinkle we can add to both examples: you can sell the contract to other parties. The contract's value depends on the time left before expiration, and the market price of the underlying asset, in this case the car. This wrinkle brings us closer to put option trading.
You can make money by buying puts on stocks if the stocks fall below a certain price within the contract's time frame. A great explanation of put buying and selling on underlying stocks can be found here.
Just as with an inverse ETF, you're going long with a put. You're not borrowing anything. The most you can lose is the money you put in (like the $1,000 I paid Bob). In this way, buying puts is less risky than shorting stocks. For example, Washington Mutual (WM) may go out of business. One way to profit from this possibility is to short the stock. Another way is to buy puts.
In terms of potential losses, look at how much more risky it is to short WM. In the last two days it's gone from under $4 a share to over $5.50 a share. It's up over 38% in two days! Suppose you had shorted the stock at $4 (if your broker let you). You might be getting a margin call now.
Had you bought puts instead, you could lose only the amount you paid. Depending on the put's expiration date, you would still have a chance to make money on the position, as it's entirely possible that WM can go down to $3 in the next few weeks. If you had shorted the stock instead, you would have to make sure you have enough cash in your account, or your broker would close your position and/or start selling your other holdings.
An advantage of puts over inverse ETFs is that you can buy them on indexes and many individual stocks. Also, as seen above, an advantage of a put is massive leverage. You can make a lot more money by buying $1,000 worth of puts than you can by shorting $1,000 worth of stock or even by buying $1,000 worth of an inverse ETF.
What's the catch? Puts expire. After the contract's time period is up, it's worthless. Consider again my contract with Bob. Suppose two years after we make the deal, the car is still worth $20,000 or more. It's not in my benefit to do anything, so I let the contract expire without exercising it. I've lost $1,000. Suppose the very next day the car's value drops to $12,000. I can buy it from the dealer for this amount, but I can't sell it to Bob for $20,000 because the contract has expired. Unless he's a complete idiot (or somehow knows that the car will be worth over $20,000 in the future), he will not buy the car from me for $20,000. Since the contract expired, he doesn't have to do anything.
With options, to make a profit you have to be right about two things: where the underlying asset's value is going (or not going), and over what period this will take place. This is the price you pay for leverage and the ability to put less money on the line.
Next time you're about to short a stock, consider whether buying a put might be a better idea.