Every stock investor knows how to “go long” on stocks.
You buy shares of a company and sell them later — hopefully, for a profit.
In other words: Buy low. Sell high.
But few investors know that you can book serious gains on falling stocks too. And even fewer people know how to do it…
Fear not, though. We’ve got you covered.
Last week, Senior Analyst Jonathan Rodriguez showed you how to use options to supercharge your gains on stocks.
Today, he’ll show you how to use options to profit handsomely on a stock’s downside — without shorting a single share.
The strategy could come in handy if the Trump-driven rally cools off.
Ahead of the tape,
Investment Director, Wall Street Daily
How to Book Massive Gains in Short Order
As Louis mentions above, most people have a pretty good understanding of how to make money on stocks as they rise.
But as you know, what goes up must come down at some point.
And there’s a killing to be made on stocks as they fall.
You see, while stocks have a natural upward bias, when they decline in price — they often do so sharply.
For instance, the S&P 500 rose 102% from 2002–07.
But it took only 355 days for the index to lose more than half of its value during the financial crisis of 2008.
So how does an investor play the downside?
Most people would sell shares short.
Short sellers borrow shares, sell them and hope to buy them back at a lower price — profiting on the difference.
Not a bad way to play a stock’s decline. But short selling comes with definite drawbacks.
For starters, your maximum gain on a short sell is 100%. Meanwhile, your downside is unlimited.
And though you may be right about a stock’s direction, as famous investor John Maynard Keynes is said to have quipped, “The market can stay irrational longer than you can stay solvent.”
In other words, bullish forces can easily overpower the bears during rallies.
So how can an investor capitalize on big drops in stocks without losing their shirt in the process?
Simply put: with options.
Last week, we covered the basics of call options.
Now let’s talk about using puts to get short — and get paid — at far less risk than short selling.
Options 101: Put Basics
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A put option is simply a contract that gives an investor the right, but not the obligation, to sell 100 shares at a certain price, at a future date.
You’ll recall that a call option allows an investor to purchase shares from the call writer at a set price and sell them at a higher market price if the underlying shares exceed the strike price.
Well, a put option allows an investor to purchase shares if they fall below the strike price — and sell them to the put writer.
There are three major advantages to buying puts to take the downside of a stock, rather than sell shares short:
Advantage 1: Cost. Just like call options, puts often trade at pennies on the dollar compared with their underlying shares.
Advantage 2: Higher profit potential. A short seller can make a maximum of only 100% on any given trade, and the shares have to drop to zero for that to happen. A put buyer, on the other hand, can easily make 100% or 200% on their options with just a few percentage points of movement of the underlying stock.
Advantage 3: Limited downside. Short sellers can suffer unlimited losses if a stock rallies. But a put buyer’s loss is limited to the amount paid for the options.
Let’s take a look at an example…
How to Book a 100% Gain on a Double-Digit Drop in Facebook
Say you think shares of Facebook Inc. (FB) are overvalued. And you predict that the stock will plummet to $110 by the end of the year.
You could simply short 100 shares. At current prices, that would run you about $13,685.
If you’re right about your hunch, you’ll book a gain of about 20%.
Not bad, but you could do much better…
The $115 put option expiring Jan. 19, 2018, would cost you $500 before fees ($5 put premium times 100 shares).
That’s a savings of 96%.
Your option breaks even if the stock falls to $110 ($115 strike price minus the $5 put premium). And the put doubles in value if the stock falls to $105.
Better still, if the stock moves against you and rallies higher during the trade, you’re only on the hook for the $500 spent on the put option.
If you sell shares short and the stock rallies, you stand to lose thousands of dollars.
As you can see, the advantages of buying puts over short selling are clear and numerous.
Bottom line: There’s a wealth of upside to playing down in stocks. And by using put options, you get far more bang for your buck — and you take on far less risk, too.
On the hunt,
Senior Analyst, Wall Street Daily