Trade Secret For being Positioned to Profit When Stocks Fall
Stock-Markets / Stock Index Trading May 14, 2015 - 11:00 AM GMTBy: ...
MoneyMorning.com 
Shah Gilani writes: I’ve been telling you about market “Disruptors” for several weeks now, and showing how these “agent-of-change” catalysts are the trigger points for some of the greatest profit opportunities you’ll find.
But that’s only part of the message I’ve been emphasizing to you in our get-togethers here.
I’ve also urged you to keep your eyes open for all profit opportunities – on both the “long” side of the market… as well as on the “short” side.
Using all the opportunities that come your way is a belief I’ve held my entire career, and it’s why my personal mantra is “There’s always a place to make money – always.”
One of those places is on the short side.
And one of the tools to use is the “put” option.
Used correctly, put options can make you a bundle.
And today we’re going to add that tool to your arsenal…
Cashing in When Prices Fall
Over the past couple of weeks, I’ve been telling you about several ways to make money when stocks, markets and even entire asset classes go down – selling short and buying inverse exchange-traded funds (ETFs).
Put options are another component of an investor’s short-side toolbox.
There are two types of options that investors and traders use all the time. Of course, there are all kinds of exotic, derivative and customized options investors can dabble in, but we’re sticking here with basic exchange-traded calls and puts.
If you purchase a call option, you’ve bought the right to buy a predetermined number of shares of a stock at a predetermined price, by a predetermined date. As the term “option” implies, it gives the investor the right to make the purchase, but doesn’t require them to do so.
An easy way to remember how call options work is to think of the word “call.” If you own a call option, you have the right to call the stock to you – to purchase the shares.
Put options are the opposite of calls. If you buy a put, you’ve purchased the right to sell a set number of shares of a certain stock at a predetermined price, by a predetermined date.
Again, an easy way to remember how puts work is to think of the word “put.” If you own a put option, you have the right to put stock onto someone – or sell it to them.
Standard exchange-traded options are traded in “contracts.” One contract controls 100 shares of stock. If you buy one put contract, you are buying the right to sell someone 100 shares of a stock or ETF.
Options have “strike” prices and “expiration” dates.
Strike prices (usually whole numbers) are price levels of the underlying stock where there are contracts that can be traded. For example, if XYZ Inc. stock is trading at $50, there will probably be options contracts with strike prices of $30, $35, $40, $45 $50, $55, $60, $65. There will probably even be higher and lower strike prices.
All option contracts have an expiration date. You can buy an option that expires this month, maybe tomorrow, maybe in a few days (they usually, but not always, expire on a Friday – and it’s typically the third Friday in a month). Or you can buy an option that expires next month, or the month after that, or six months from now – and sometimes much further in the future.
We’re talking today about put options.So from here on, we’ll leave call options out of our discussion.
I’m going to show you how puts work – including some detailed examples.
But before I do that, I want to explain how puts fit into our “Disruptor” strategy.
Profiting From Change
Disruptors are catalysts that interrupt the status quo. And they’re not just technology focused – you know, like the latest piece of software, new Web device or newest drug.
Disruptors can be economic, financial, governmental and even personal. They change the rules of the game. They change the playing field. They change where the money is flowing.
Here in the United States, the fracking boom – which is pointing us toward energy independence – is an example of an economic “Disruptor.”
Think about the way the U.S. Federal Reserve intervened in the financial crisis – slashing interest rates to zero and instituting the whole “quantitative easing” deal. That’s been a financial Disruptor.
And the U.S. Food and Drug Administration (FDA) decision to create a “Breakthrough Therapy” designation that “fast tracks” new drugs to market is an example of a governmental Disruptor.
In China, the massive migration of people from the distant agrarian provinces and into the big cities – the biggest mass migration in human history, in fact – is an example of a personal Disruptor.
When the rules, playing fields and money flows change, so does the “pecking order” of players involved in the affected sector.
In other words, winners become losers, losers become winners and new players emerge to profit.
Most investors focus on the winners – and look for ways to profit on the long side – by purchasing and owning those shares.
But you can also profit – dramatically, in fact – in cases where formerly dominant winners are leapfrogged by new players… and become losers.
Those are stocks you want to “short.”
And put options are one very good way to do that.
Let me show you how put options work.
Putting It to the Test
Let’s say you’ve been watching XYZ stock, or maybe you own XYZ stock. It’s gone up from $30 to $50 to $70 and is now going back down and is trading at $52.
Let’s say you’ve done your homework, and you believe XYZ’s slide is going to continue – the stock might even collapse.
Of course, you want to protect the profit you have if you bought it lower, or prevent any further loss if you bought it at a higher price. Or maybe you just want to put on a trade that will make money if XYZ goes down – because you know the company is about to get “leapfrogged” by a landscape-changing Disruptor.
No matter reason – to protect profits or to make money – you can capitalize on your belief that a stock is going lower.
You can buy puts.
The four things you will have to consider are:
- How many contracts do you want to own?
- What strike price do you want to use?
- What expiration date do you want to consider?
- How much should you pay for a contract?
Let’s say you own 100 shares of XYZ and want to sell that many shares in the future. You would want to buy one put contract, because one contract allows you to control and sell 100 shares. If you have 200 shares, you would want to buy two put contracts, and so on.
If you are speculating, you have to consider how many put contracts you want to buy based on how much each contract will cost you and how much money you are risking.
The price of an option, which controls 100 shares, is expressed in what seems like a small amount. Maybe the option is 25 cents, or $2.50, or $10.
That isn’t the whole price. It is the price you pay per share. Don’t forget: One contract is for 100 shares.
So, if the option price is 25 cents, you have to multiply 25 cents times 100 shares to get the cost of one contract. In this case, one option contract would cost you $25.
If I tell you I paid $2.50 for my put options, you would have to quickly multiply $2.50 times 100 shares to know that I actually paid a total of $250 for one contract. An option contract at $25 (per share) would cost you $2,500.
Time to Buy
When I decide I want to buy a put option, my first consideration is always the time element: When do I think the stock will fall?
There’s no point in buying a put option that expires in June if I think the stock won’t fall hard until we get closer to the end of summer, or after the election or some other long-term time frame. So, I’ll first look at the expiration month I want.
It’s May now, but maybe I’ll choose a September-expiration put option because I think XYZ stock will start falling as the summer comes to a close (because my made-up stock XYZ makes pool cleaning equipment and sells its services in early-fall New England).
While you may guess right that XYZ, which is now at $52, is going to $40, if you buy a $40 strike price put contract that expires in June but XYZ doesn’t fall below $40 until September, your contract would expire and be worthless.
The thing to remember about expiration months is that the further out you go the more the option will cost you. That’s because you are paying for more time – and time costs money.
Besides, there’s a person on the other end of the sale to you of those XYZ put options, and that person is selling you the right to put stock (sell stock) to them, not for a few weeks, but for the next four months. The more time you buy for the stock to do what you think it will do, the more you are going to pay.
Here’s the next thing I ask myself: What strike price do I want to buy?
Because XYZ is now at $52 and I think it will go lower, I have to determine which strike price based on how low I think XYZ might go by the September expiration date. And what’s the best price to pay, since different strike price put options cost different amounts to buy?
The final consideration: How much will have to pay for the put options I want to buy?
Let’s go back to XYZ stock. It’s trading at $52 now, and I think it’s going to $40 by early September. I have lots of options.
If I look at the September works $60 puts, they might be priced at $10. The September $50 puts might be priced at $5, and maybe the $45 puts are priced at $2, and maybe the $40 puts are prices at 25 cents.
That’s a big difference in cost.
September $60 puts allow me, until the contract expires on the third Friday in September, to sell 100 shares (for one contract) of XYZ to the person who sold me the option contract at $60 a share, any time between now and then.
If I pay $10 to have the right to sell XYZ at $60, it doesn’t do me any good today, because even though I could sell stock at $60 today (it’s actually trading at $52 today), that put option cost me $10. That means I could sell stock today for $60 and collect $60 a share, but it cost me $10 a share. So I’d net $50 a share if I “exercised” my September $60 strike price put option today.
Exercised means you exercise your right under the contract. Your right is to sell stock at $60 a share to someone. When you exercise your option, you’re selling 100 shares for $60 per share. In other words, you’d collect $6,000 for selling 100 shares.
The Whys Have It
Why would you ever sell stock at a net price of $50 today (you sold stock at $60 a share based on the strike price you owned, but you paid $10 a share for the option contract, so you actually netted $50 per share) if the actual price in the market you can sell stock at is $52 a share?
You wouldn’t.
To calculate your breakeven price for the put option, you take the strike price and subtract the cost of the option. The strike is $60, and it cost you $10, so your breakeven is $50. The stock has to fall to $50 by expiration for you to be able to sell the option you bought and break even.
Did you catch that? You can sell your option at any time before expiration.
You see, to make money, you don’t actually have to exercise your option and sell stock. If you owned shares and exercised your put option and sold stock, you’d be out of the stock you owned, because when you sell stock you have to deliver shares to the buyer. Your broker would take the shares out of your account and deliver them to the person who you forced to buy them from you at $60.
If you exercise your put option to sell shares to someone and you don’t actually own any shares, that’s fine, too. You just end up being “short” the shares you sold. At some point, you’re going to have to buy back those short shares.
I talked about covering shorts in a previous article. You can refresh yourself here.
Your third option is the most common option that option buyers choose. You can simply take the put option you bought and sell it to someone else.
Whether you make money when you sell the option depends on the price of the option at the time you sell it, and that depends on what the price of the underlying stock is and how much time there is left on your option contract for the person who buys it from you.
That brings us back to our stock XYZ.
If the stock is at $52 now and I think it will be at $40 by September, I could buy the $60 puts, but they’re expensive. If I buy them and XYZ looks like it will close at $40 on expiration day, I’d probably sell them the day before to lock in my profit.
They would be worth $20 a share (or $2,000 a contract) because I could sell someone stock at $60 and buy it back for $40 and make $20 a share. Or I could sell the option to someone, which would be worth about $20.
But, I paid $10, remember?
Strike Force
So I actually make $10 a share. I paid $10, made that $10 back and made an additional $10. So, by selling my option for $20, I made a 100% return on my trade.
But I might not want to pay $10 a share for the $60 strike-price put options. There are cheaper options.
I’d probably buy the $45 strike or the $40 strike put options if I was confident XYZ would fall there by September expiration. They’re a lot cheaper, I can buy more of them for the same amount of money (that’s leverage) and I’d have much bigger gains if I buy those strike-price options.
The $45 strike put options are going for $2 now. If XYZ is at $40 on – or before – expiration, those options will be worth at least $5, because $45 (the strike price) minus the price of the stock when it gets to $40 is $5. That’s the minimum price someone else will pay me for my options before they expire.
If I made $5 and paid $2, my profit is $3 per share, or a 150% return.
The best I could have done would have been to buy the $40 strike put options and bet the farm. If I had $1,000 to invest, remember I could have paid $10 a share for the $60 strike put options, which would have cost me $1,000. But instead, I spent $1,000 buying $40 strike put options for 25 cents a share (25 cents times 100 shares = $25 per contract); for my $1,000, I could have bought 40 contracts!
Before expiration, my $40 strike put options would rise in price as the stock falls toward $40. If it’s two months, or a month, or a few weeks before expiration – and XYZ is getting close to $40 – people will want to buy my $40 put options. The reason: They’re still cheaper than the higher strike-priced put options, but worth paying up for.
Based on this hypothetical situation and my extensive experience trading options on the floor of the Chicago Board Options Exchange (CBOE), I’d guess I could sell my $40 strike puts for at least a dollar sometime before expiration – and probably for a lot more than a dollar.
But at a dollar each, after paying 25 cents each, I’d make $4,000. That’s because for a $1,000 investment at only 25-cents a share ($25 per contract) I could buy 40 contracts. Because 40 contracts control 4,000 shares (40 × 100), I’d be selling 4,000 shares worth of stock at $1, which would be a 400% gain on the trade.
That’s what you can do with put options.
Sure, there’s more to how they’re priced, which is complicated and has to do with volatility, interest rates and time to expiration. And sure, you can lose everything you pay for a put option if it expires worthless.
But, now you know something important about puts. You can make them work for you in down markets. And you can use them to profit when economic Disruptors transform once-powerful market leaders into sector also-rans.
This is some complex stuff, so feel free to post questions below. I’ll be sure to answer them in a future report.
[Editor’s Note: We encourage you all to “like” and “follow” Shah on Facebook and Twitter. Once you’re there, we’ll work together to uncover Wall Street’s latest debaucheries – and then bank some sky-high profits.]
Money Morning/The Money Map Report
©2015 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com
Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.
© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.
