Put Options

The Smart Profits Report: Issue #102
Wednesday, April 14, 2004

Put Options: Why Short a Stock when You Can Buy a Put?
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Are you getting everything you can out of the market? Most investors aren’t. They miss thousands of opportunities because they are chronically bullish. The market, however, isn’t. Not only do the market AND individual stocks fall, but their drops tend to be dramatic and rapid.

Knowing how to capture this “other” side of the profit equation increases your ability to make money in all conditions. Some investors who are wise to this do it by shorting stocks (see definition below). But I have a better suggestion: Buy put options when you think a stock or index will fall. Puts allow you to “short” a stock with much less risk.

Put Options Offer Less Risk & More Profit Potential

If there is an opportunity to buy a put option versus shorting a stock outright, I will always use a put. Let me show you why:

When you buy a put, your loss - if you have one - is limited ONLY to the amount you have invested in the put option.

Think back to the Internet stock boom. Back then, individual stock prices were moving $20 to $50 in a week. They became terribly overvalued, and at some point that bubble had to burst.

If you shorted Amazon at $100, the stock might have gone up to $150 a week later. As a short trader, that would have hit you with a huge loss.

To short a stock, you borrow shares from a brokerage account and sell them into the market. But you’re not done. In order to close out your position, or “cover,” you must replace those borrowed shares. You do that by buying shares yourself at whatever price they are trading for.

Shorting the Stock vs. Put Options

That’s fine if the shares have gone down as you expected. But in our Amazon case, you would have had to buy shares at $150 a week later - a major loss. Yes, you would have received $100,000 when you shorted a thousand shares of Amazon. But when you covered, you would have spent $150,000 to buy the replacement shares. That’s a $50,000 loss. Trust me, it happened to lots of people.

So when you short a stock, you can lose MORE than 100%. Remember that Amazon climbed from $45 to $143 from June to July 1998. Imagine that poor short seller. He would have lost 217% (plus margin costs) and nearly a $100,000 dollars shorting a thousand shares of Amazon then.

But if he’d bought a put option for $5 or less, even if he was totally wrong, his maximum loss would have been only $5,000 (because generally you buy options in “lots” of 1,000).

By the way, after that run, Amazon fell from $143 to $76 over the next six weeks. The smart trader with the put option could have made anywhere from 500% to over 10,000% depending on which option month he took; while the guy who shorted made “only” 46%.

Popping Profitable Bubbles Every Day

You don’t need another Internet bubble to make money on puts. These opportunities arise all the time. Some weeks ago I shorted Martha Stewart Omnimedia twice: I shorted the shares before the verdict and then right after.

But I did it with puts, instead of selling the shares short. And I made money. I bought my first puts at $0.25 a share and got out early. They went as high as $1.60 a share. On the second set of puts, right after the verdict, I made 40% in two days.

That was a special case for me. I don’t usually buy puts for an overnight trade. But, in this case I knew one thing for sure: I had a 50-50 chance to make money on the trades. And a firm limit on how much I could lose. (Those odds are significantly better than buying or selling a short-term option without any significant upcoming event.)

Now, I am not sharing the Martha trade to brag about a win. I want to point out that if I had shorted the stock, as many people did, I would have lost a lot of money if the jury had decided Martha was not guilty. And while it’s true that buying puts in the face of a Martha victory likely would have resulted in a loss, too, it wouldn’t have been nearly as damaging to my portfolio.

Regardless, this was a winning trade for us.

If you recall, the shares were halted at $16 when the verdict came out. The shares moved $3 on the day, and fell $6 after the verdict. That was good for the short sellers - even better for us option traders with puts. (But again, if the verdict had gone the other way, the shares could have rocketed up to open at $20 or $25, resulting in a huge loss.)

Double Your Market Agility & Your Number of Opportunities With Put Options

This is the lesson: If you want to double your market agility immediately, you need to think about making money on negatives, too. And if you want to short a stock, using a put option will limit your loss and offer you unlimited upside.

If you haven’t been thinking in the negative, start now. Follow some stocks that you think are overpriced. Look for news that will drive them down. In coming letters, I’ll show you how to follow through on those ideas and turn them into good option trades.

Good Trading,

Karim

Today’s Smart Profits Crib Sheet

For a detailed definition of “put option” or “volatility,” just visit our handy Smart Profits Glossary.
Check out Smart Profits #131, Put/Call Ratio - When this Number Jumps, It’s Time to Trade, to learn how to watch for changes to come in your positions.

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