Before yesterday, I have never actually taken a position where I profited when a stock would decrease in price. The reason was simply because I lacked the understanding and education as to how I would actually be able to do it short of shorting a company’s stock. That is when I learned of another, much less riskier way which is buying in the money puts.
What Does Shorting a Stock Mean?
Most individual investors are “long” on stocks, meaning that they are betting, hoping, wishing that the particular equity that they are buying is going to increase in price. That is the entire basis of my growth dividend investment fund. When someone is “short” on a stock that means they believe that the particular equity (maybe it is a stock, but it easily could be an index) is going to decrease over some time. So, according to Investopedia, when one shorts,
…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.
It is actually a very simple concept. I think Company ABC is going to decrease from its current price of $5, so I borrow 10 shares at $5 from my broker, those shares are then sold and $50 is dropped into my account. Remember, I borrowed the shares so every month interest is going to be charged from the account. Two results:
- The stock decreases in price from $5 to $1. I “cover” and give my broker back 10 shares but this time it only cost me $10 to buy the stock and so I profit $40 (minus fees and minus interest) on the transaction.
- The stock increases in price from $5 to $10 and to cover I now have to spend $100 to get those same 10 shares (plus all those same fees and interest payments).
Due to the risk in scenario 2 the risk for shorting a stock is very high. Much too high for my risk tolerance which is why I never bet against a stock…that was until yesterday when I executed another way that I recently learned.
What Does Buying a Put Option Contract Mean?
There are entire blogs, books and sites dedicated to option contracts so this post is obviously going to be just a primer on this particular strategy. The Chicago Board Options Exchange provides a 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.
My Experience Buying a Long Put Option
I will provide detail of the trade in my next options-IRA Post since that is the account I used since I didn’t want to deal with the tax ramifications of the moving parts. Notwithstanding details of the trade, I feel very strongly that not only is this particular company is going to decrease in price 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 bought 2 contracts that were right around the money (unfortunately I learned about this technique after a 4% drop) with a June 2013 expiration. As indicated in the picture I need the stock to drop below the Strike Price PLUS the premium paid for the 2 option contracts. I don’t see the technique replacing my covered call on small cap stocks which has been going great but it will be nice for those times I get these hunches!
From my reading on the topic, it seems that the covered calls that I participate and the long put that I just learned about are literally the two simplest techniques in the option world. I am excited to learn more about this world.