Using Puts to Bet On a Decline

Today, we're going to talk about how you can use a put to bet on a decline in a stock. Before we start, let's review what a put is; a put gives the buyer the right, but not the obligation, to sell a stock at a specified price.

Learning to Speak Optionese: Using Puts to Bet on a Decline

So how do you make money when you buy a put? Since put's give the buyer the right to sell, they want the stock to move below the strike price of their put to make a profit. When you can sell a stock for more than what you can buy it for, you make the money in between the two prices. Buying a put is similar to shorting a stock, with one very important difference: when you buy a put you can only lose the premium you paid when you opened the position. In contrast, when you short a stock, your potential loss is unlimited.

Let's look at an example,

Puts and Motorola

After Motorola (MOT) beat earnings this quarter it began to rally. The profits were ripe on the long side, and the bulls prevailed. Sadly, the rally began to run out of steam at an unfortunate moment. As MOT closed on November 5^th, it sat at a familiar peak. MOT had formed a double top! The next trading day MOT fell 5%, confirming to those watching the charts that the MOT rally was likely over. As the market closed this past Friday, MOT puts were particularly attractive. MOT puts expiring in November with a strike price of 9 traded at .39 and November 8's were trading at .07.

Traders are unsure of exactly where MOT's stock price will go in the two weeks before expiration, but with a few well purchased puts they can easily profit from MOT's potential decline. One trader, Phil, believes MOT will fall well below 8 before expiration. He thinks MOT will easily trade in the low 7's by the end of the week. However, his coworker Bob disagrees. "If MOT does indeed decline," says Bob, "the 7.70's will be the bottom." Bob and Phil have two different opinions of where MOT is going. Let's look at what put's they should buy to best profit from their positions.

First, let's consider what Phil should do. Phil believes MOT is going to the low 7's. Both the 9 and 8 put options are well priced in the case of MOT, but if MOT is going to 7, what will give Phil the maximum profit? In Phil's case, despite the fact that the November 8 puts only have time value, he should be a buyer of the 8's. If MOT does go to 7 before expiration, Phil will make .93 a contract, or an incredible 1328.57% return! Despite how great that large percentage looks, if MOT stays in the 8's Phil will lose all the money he spent on the November 8 put's when the options expire! Surely Bob will make fun of him if that happens.

On the other hand, Bob will likely buy the November 9 puts. He is bearish on MOT. He even thinks MOT will fall below 8. However, Bob likes the November 9 puts because they already have some intrinsic value, and will lose their time value slower than the November 8's. Plus, if MOT does not fall as much as he expects he will still be able to get out of the trade a winner!

As you saw in the case of Bob and Phil, when purchasing puts you must consider your price target and risk level. The puts that are farther away from profit when you purchase them are riskier than puts near the current strike price. Despite the risk, puts such as the MOT November 8's offer significant rewards for a speculator like Phil who is anticipating a steep drop in the price of a stock. The puts closest to the current price of the stock are a little safer (although, in both situations you could quickly lose your entire premium). These sorts of puts are ideal for a more disciplined, realistic trader like Bob. Overall, puts are a superior alternative to short selling, which can be utilized for large returns without unnecessary market exposure.

Until next time,

Spencer Sundahl