Profit From Falling Stocks Without Taking On Unlimited Risk

Want the rewards of betting against a stock without all the risks associated with shorting?

Then buying put options may be the answer.

A put is a type of options contract. It gives the owner the right, but not the obligation, to sell 100 shares of the underlying stock at a specified price (known as the “strike price”) at any time before the expiration date.

Changes in the price of the underlying stock will lead to a change in the value of the put. So will changes in the volatility of the underlying stock. If the stock experiences volatility, the put should go up in price. This is because there is a greater chance (all else being equal) it will reach the strike price by the expiration date. Falling volatility lowers this chance, so it should decrease the value of the put.

In addition, the put will also change in value based on how much time is left until the expiration date. All else equal, the put will be less valuable as it gets closer to the expiration date.

Today, let’s focus on buying put options. We’ll cover the reasons to buy put options, how they work, and the various reasons a trader might use them…

How Traders Use Put Options

Buying put options gives the trader a chance to enjoy the benefits of leverage, paying relatively large rewards for a defined amount of risk. Traders who buy puts are typically bearish on a stock. There are also option contracts available on some ETFs, indexes, and futures.

For example, let’s say we buy a put option contract on ABC stock at the $50 strike price that expires in six weeks with a buy limit of $4. That day, ABC is trading at $52, so our option has no intrinsic value. Two weeks later, ABC releases disappointing quarterly results that send its share price down to $40.

At that point, our option has $10 of intrinsic value ($50 strike price minus $40 current stock price). However, since there is still a month left until this option expires it is trading for $14 which includes a $4 time premium to reflect the potential loss that may occur during the time remaining. In this case, we elect to close out this position by selling the exact same option for $14. At that price, our gross profit is $10 ($14 sell price minus $4 buy price). That works out to a return on investment (ROI) of 250% ($4 buy price divided into $10 gross profit).

Why Put Options Matter To Traders

Traders can use puts to make bearish bets on individual stocks. Because puts have various expiration dates, a trader can make a short-term bet or a longer-term trade. They also help traders hedge their portfolios and profit in bear markets. Put options are also appealing because of their limited loss potential. They are often preferable to selling individual stocks short, since shorts carry (theoretically) unlimited risks for traders.

Editor’s Note: With the tech-heavy Nasdaq at record highs, some well-known names have gotten overheated. And according to our colleague Jim Pearce, that makes right now a perfect time to use this strategy to bet against some of these over-hyped “story stocks”…

As chief investment strategist of Mayhem Trader, Jim has pinpointed the most vulnerable stocks that are ready to take a tumble. To learn what he’s targeting to profit when the mayhem strikes, click here.