Birds_heading_south-300x196One of the great features of stock options is leverage. When many people think about option trading they tend to think about the classic option play of buying a call as a proxy for a stock. But with options, you can do much more than use them as a leveraged substitute for a bullish position on a stock. Options are a great way to position yourself when you are bearish on a stock, too.

Here’s where a more sophisticated trader might consider using puts. It works like this. Let’s say XYZ Corp. pre-announces bad earnings, investors dump the stock causing the 50-day moving average of the stock price to cross below the 200-day, and your favorite TV stock pundit says he’d rather sit through a Kevin Costner movie marathon than own this stock. If you think the stock has entered into a prolonged downtrend, you may consider shorting the stock in order to profit from the downtrend. Not so fast – there may be a better way. Instead of shorting the stock, and having unlimited up-side risk, not to mention tying up a lot of capital to meet margin requirements, we can buy an at-the-money put.

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With the stock trading at $50, one could buy an “at-the-money” call option (i.e., a strike price of $50) for $2.30. The benefit to buying the put is that if the forecast is wrong and the stock moves higher, there is a limit on how much money will be lost. When buying an option, the most you can lose is what you pay for it — in this case $2.30 per share (not including commissions). The profit potential however is substantial — although I’ve never seen a stock go to infinity, I have seen them go to zero.

If XYZ stock is trading above the strike-price of $50 at expiration, both positions are losers. But, the losses on the put option are capped at $230 whereas the potential loss on the short stock is unlimited. Sound good, no? There is a small trade-off, however, and it comes into play if your bearish forecast is correct and the stock is trading below $50 at expiration. Here, the short stock position is profitable at any point below $50. The put, by contrast, is not profitable until the stock falls below $47.70 (the strike price of $50 minus the premium paid of $2.30). In dollar-terms, the put will always underperform the short stock position by the amount of the option’s premium. But from a leverage perspective, a 10% move lower in the stock yields over a 100% profit.

All this is assuming the position is held until expiration. Most traders take their profits and run sometime before the option expires. This put may show a profit between $50 and $47.70 if the move downwards occurs sometime before expiration. This is because the option will still have some time premium. The sooner the price drop occurs the better.

So, what is the next great options trading play? As we sift through a myriad of stocks to find one that we believe will have a great run up in price, it may behoove us as well to search for some stocks we think are heading south.

 

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