Why is it more common for Institutional Traders to short sell stocks when they have a bearish stance instead of Buying Puts? The limited loss potential of Buying Puts seems like a better choice.
In my opinion, professionals mainly trade options if they want to trade the volatility. I believe there is a mathematical proof that shows that if the realized underlying volatility between the option inception and maturity exceeds the implied volatility of the option (priced in at inception of the option), the option seller would lose money if they delta-hedge the option.
On the other-hand, if the realized volatility of the underlying does not exceed the implied volatility of the option, the option seller would make money whilst delta-hedging the option from inception through to maturity.*
I believe that the above strategy (selling an option and delta-hedging it, whilst hoping to make money on the fact that the realized vol won't be higher than the implied vol of the option) is called gamma trading of options.
I believe you can also vega-trade the options, which simply means you buy the option in the hope that the implied vol will increase & sell it later (or you short the option hoping that the implied vol decrease and buy it back later).
When a market maker sells an option, there will be some "risk-premium" embedded into the option price, which in effect means that the market maker prices a premium into the implied vol of the option: in other words, the market maker will typically set the IV higher than what he believes will be the actual realized volatility of the underlying. Therefore (intuitively) if you want to bet on the stock price going down, buying a put could have a higher "risk-premium" charged into it than what it would cost you to simply short the stock (i.e. the risk premium in the put option will erode some of your profit, even if you get the direction right: but if the stock is difficult to borrow or too expensive to borrow, it could be beneficial to just buy puts).
Ps: in addition to gamma & vega trading of options, institutional investors also buy (OTM) puts as a protection for large downside moves (I believe that mutual funds holding large positions in some equities use puts as an "insurance" for their portfolios). As Dimitri pointed out in the comment, (OTM) Call options can also be bought as a protection when institutional investors short stocks (as indeed they should have done with GameCorp).
*(see: Jim Gatheral, Nassim Nicholas Taleb - The volatility surface: A practitioner's guide (2006), page 154).
In addition to other reasons mentioned here, options tend to be expensive to trade (they have high bid-ask spreads). These do add up in institutional asset management, so best avoided.
Further, if trading options at any significant scale, the underwriter of the option will end up shorting the stock anyway, to cover their own risk. As the price fluctuates, and the option's non-linear payoff changes, the underwriter will need to do additional trading in the asset to manage their risk. They will effectively pass their costs onto the trader (part of the reason why options are expensive to trade). Even after hedging with a short position, there will be some residual risk left, for which the underwriter will charge more premium.
So you might as well cut out the middleman and short the stock yourself.
But traders certainly do make use of options, just not as the main go-to instrument.
At the risk of making maybe three obvious points:
1- Many funds' investment theses are not predicated on a particular price point on a specific expiry date. They simply believe that X is too high relative to Y, which is too low relative to X. Expressing this view via an options position would implicitly require them to take an additional view about the optimal/expected scale of any reversal of this imbalance at a fixed point in time. Pragmatically, it would also create a more difficult hedging problem for the fund. It actually creates more things that can go wrong.
Simple example - imagine that say A and B are virtually lookalike businesses, and you can't believe that their relative valuations are fair. So you want to short A to buy B, for the convergence trade. One of traders rocks up and tells you that puts are better than shorting... so you buy puts in A instead. You then think you should sell puts in B? If the market rallies 10%, your position becomes completely unconnected to A-vs-B. You just collect the spread in the premiums paid/received on your options. If the market crashes, you will lose money because your short put losses on B will almost certainly be far larger than the premiums received from A. Options actually complicate a simple view; and cause the portfolio to diverge from the simple investment thesis whenever the market moves.
2- More often than not, ex-post realised volatility plays out lower than ex-ante implied volatility. Which makes the buying of options (calls as well as puts) a less profitable strategy than the selling of them. Because the insurers receive frequent small profits and suffer infrequent huge losses, there is a risk premium to volatility exposures. The whole carry in FX (and the structure of returns in credit) is pretty much the same thing in different asset classes.
This means that investors in aggregate will over the long-haul not be paid for rolling puts versus just short-selling. And they will be, in aggregate, paid for selling puts. Even if, yes, some of them do individually go bust for doing this in the wrong things at the wrong times.
Some studies have looked at this, from the perspective of buying a call and selling a put every month. Which is obviously equivalent to just buying the futures. And then decomposing the market return into a long-call versus short-put contributions. Results vary a bit; but around ~70% of stock returns come from the put side versus ~30% from the calls. IE stock returns are 2/3rds willingness to take the rough, absence of disaster; 1/3rds participation in riding the smooth, capitalist progress.
Seen thus if you are equity investor, buying puts is swimming against the tide (of pricing biases, not sentiment, expectations or consensus) before you even consider the investment case for the downside.
3- Finally, please don't forget that any options trader might have other positions in his portfolio. I might be long puts. But I own the underlying, the two combined just means I'm actually net long calls! This position is often NOT a bullish position at all... it's often what scared investors who have to own some banks in their portfolio for benachmark reasons do. They have to own the banks, but they put-protect. So they are long call. Very different from someone who thinks that UniCredit or WellsFargo is going to rally 20% next month... Just like the vast majority of call sellers aren't bearish, but own the stock and are overwriting to scalp for yield...
The vast majority of equity positions are long, and the shorts are a niche but important sideline to this. Given this, the incentives for investors positioning in options might be VERY VERY different to those taught in textbooks, seeing the options leg of the whole in isolation.
Most equity investors (at least the institutional ones) will ask three questions here. You either have to believe my word for their mindset; or think I'm talking my book here.
"Occam's Razor: you're selling me on complicated rather than simple?" [soon followed by: "what are your profit margins on the two, please?"]
"I'm a stockpicker - why am I buying the VIX?"
"Options are insurance. I use that to protect against unavoidable risks that I'm really scared about. Why would I seek exposures to avoidable risks?"
Cost. And greed.
They want to squeeze every penny that is possible out of their transaction.
It costs much less, maybe nothing, to short stocks that do not even exist. However the risk is substantial in case someone tries the short squeeze on you, as you could lose your shirt.
This is just another example of the black swan biting those who do not really know what a normal distribution is and why it is only a crude approximation of reality.
Options cost money. And you are also at risk for closing them out in a timely manner and for the seller being able to cover the entire value.
Two main reasons:
- cost/premium: there is upfront premium associated with purchase of any put option. If your option ends up out of money, your premium is lost. for example, if stock price remains where it is (or higher than strike of your option), you will still end up losing money via premium
- timing: Even if your bet is correct that eventually stock goes down, if you have expressed your view via option then there is a risk that stock may not go down within time period of your option expiry. It may happen that stock remains at same price, your option expires and then the next day (or next hour), stock eventually crashes. In this scenario, you will miss out on the profit you should have made.
There are two main reasons why an institutional trader (or anyone else for that matter) may prefer to short an asset rather than go long on puts.
Timing: Shorting gives the trader the ability to cash out of the position whenever they please, whereas a put option may not, depending on its conditions.
Risk: Although a put option may magnify the potential upside (a lot), it also means the trader loses 100% of their investment if the asset price doesn't fall below the strike price and the option expires worthless.
Shorting, by contrast, wouldn't give the same profit opportunities as a put, but also means the trader might get some (or close to all) of their money back in the event of the asset price being above the strike price.
- Shorting: You short a stock worth \$100, and a month later it's worth \$120. You lost approximately \$20, and you still have \$80.
- Long Put Option: If you purchased \$100 worth of put options with strike price \$100 on the same stock, and the price is at $120 at expiry, you lose all of your \$100 investment (!)