Back in January I discussed that I was jumping in with the bears on a particular stock and actually betting that a company would be worth less than what it was at a future date. In that post I discuss the difference between the two main options I knew about when trying to profit off a falling company – Shorting a Stock and Buying a Put.
To give a quick recap:
According to Investopedia when you short a stock,
…your broker will lend it to you. The stock will come from the brokerage’s own inventory, from another one of the firm’s customers, or from another brokerage firm. The shares are sold and the proceeds are credited to your account. Sooner or later, you must “close” the short by buying back the same number of shares (called covering) and returning them to your broker.
This risk was always way too high for me. If the stock took off in the opposite direction (i.e. was worth more) my risk could be theoretically unlimited (although I would probably have to “close” a lot sooner). Side note: when too many people are closing out their shorts because the stock price is increasing it is called a short squeeze.
So with that being the only way to bet against a stock I never traded on my gut that a stock was going down in price…that was until I learned about a particular option play. Better explained by The Chicago Board Options Exchange in their fantastic introduction on the topic of buying puts:
Buying an equity put gives the owner the right, but not the obligation, to sell 100 shares of underlying stock at a specified price (the strike price) at any time before a specific time (the expiration date). This is a bearish strategy because the value of the put tends to increase as the price of the underlying stock declines. This gain in option value will increasingly reflect a decline in the value of the underlying shares when the stock’s market price moves below the option’s strike price.
The profit potential is significant as the underlying stock continues to decline, and is limited only by a potential decrease in the stock’s price to no less than zero. The financial risk is limited to the total premium paid for the option, no matter how high the underlying stock increases in price. Investors find this limited risk more attractive than the unlimited upside risk incurred from selling 100 shares of stock short. In addition, a short seller of underlying shares must pay any dividends distributed to shareholders while the short position is held; a put holder does not. The break-even point is an underlying stock price equal to the put’s strike price minus the premium paid for the contract. As with any long option, an increase in volatility has a positive financial effect on the long put strategy while decreasing volatility has a negative effect. Time decay has a negative effect. emphasis added.
My Experience and Numbers Behind Buying a Long Put Option
I didn’t want to provide the name of the equity prior to it closing out, but the company I was investing against was Lululemon. I listed the reasons in that original post
1) because analysts have already seemed to turn;
2) the company has already said they missed estimates
3) the company is already valued at a 40+ P/E and
4) the company, in my opinion is a fad.
So I put my money where my mouth was and bought a long put option against Lulu:
What the above order confirmation is saying is that on January 17, 2013 I bought two puts that expires(expired) on June 22, 2013 for a total cost of $1,389.53 ($6.90 was the contract price). So if the stock on June 22, closed:
- Above $67.50 I was out nearly $1,400
- Below $60.60 excluding fees I was making some cash!
- In between that amount I’d be loosing some of my $1,400 but the closer I came to that magic $60.60 number (a little below when we take into account fees) the less I would be losing.
Well, it was a bumpy ride to say the least. First I was the smartest man to ever live:
I mean inside two months the company dropped over 6% – it was only March and I was basically already there. Another two months to go? Hell I was already making it rain somewhere. The reason was that the company had shipped some see through pants and for some reason STILL unknown to me this was a bad thing.
and then the bad times set in:
Yeah then it went on a MAD dash to over $80! The making it rain party was no more? Hell I was thinking I was going to have to go dance somewhere for quarters since no one is paying me with whole dollars to dance. And then I got really really really lucky:
The stock plummeted when the CEO-Founder suddenly announced her future resignation and earnings weren’t as good as expected.
End Result of the Trade
I had to buy 200 shares of Lulu (so I can “put them to someone else” at the higher price).
So, we take the difference between these transactions $1,239.04 and take into account what it cost me to execute the trade $1,389.53 (all fees included) and we have a final loss of $150.49. Much better than the $1,389.53 loss I was looking at when the bad times hit lol.
Would I Purchase a Long Put Strategy Again?