Stock Tip of the Week: Short Puts

It may sound strange but shorting puts can be one of the safest ways to invest. Put and call options are ways of speculating on the price movements of stocks providing much greater percentage returns (and percentage losses). A call is the right to buy a stock at a particular price within a particular amount of time. The call purchaser hopes that the stock will go up and if it does, the percentage gain will be far more than if just the stock is purchased. If the call is not exercised by the expiration date, the call expires worthless. If you sell (short) a call and you own the stock, if your stock doesn't get called and the call expires worthless, you get to keep the proceeds, the premium, which is a way of generating income, or additional income if the stock is already a dividend payer, on the stock. Options are traded on a per share basis but representing 100 shares. In other words, If a call option is selling for 3.75, it means that the option cost would be $375 and it would give the buyer the right to buy 100 shares.

A put is the reverse. It is the right to sell a stock at a specific price within a particular period of time. Often, owners of a stock buy a put to protect them on the downside. There could be several reasons for this: postponing a capital gain to the following year, uncertainty about upcoming earnings call, belief in a potential market drop. Another reason to buy a put is to speculate that the stock will drop; an alternative to shorting the stock. However, the seller of a put is hoping that the stock will go up and the put will become worthless. If the stock drops, the price of the put will increase and the trader who shorts the put would lose money but would lose less money than if the stock was purchased.

This is where an overlooked trading technique comes in to play. Let's look at a hypothetical example. Suppose XYZ stock is trading at 21 a share. Assume that a one month put with an exercise price, or strike price, of 20 is selling at 1. The buyer of the hopes that it drops significantly. If the stock drops to 17, the put buyer can buy the stock at 17 and 'put' it to the seller of the put at 20, for a 3 point gross profit or after the investment of 1, a net profit of 2, not counting commissions. Or as a simpler alternative, the put would be worth 3 points and could just be sold, for a 200% profit.

Now let's look at the seller of the put. If you are bullish on XYZ stock, you can buy 100 shares of the stock for 21. If the stock does nothing, you make nothing. If the stock goes up 1 point to 22, you make a $100 profit. if it drops to 17, you lose $400. Now here's the tip. If you short the put, and the stock does nothing, the put will expire worthless and you make $100. If the stock goes to 22, the value of the put drops to zero still expiring worthless, and you make a $100 profit. Now suppose that the stock drops to 17, the put is now worth 3, and since it was shorted at 1, it is a net loss of 2 or $200, a much lower loss than if you had bought the stock.

The alternative is that you could have had the stock put to you, meaning that you would be forced to buy the stock at 20. But you would still have been better off than if you had just bought the stock at 21. You end up buying a stock that you wanted, but at a dollar less per share, plus you get to keep the one dollar premium so your cost basis is actually 19. This on a stock that you were willing to pay 21 for. Therefore, the breakeven is 19. If the stock drops drops to 19, the value of the put is 1 which is where you shorted it at.

If you really want the stock, there are other ways to play the short put. You could short an at-the-money or slightly in-the-money put, giving you a greater chance of getting put to, and still capturing the premium on the option.

This technique has the advantage of time in your favor. The closer to expiration, the faster the value of the put depreciates. Now the disadvantages. Unless the stock is put to you, you lose upside potential. Also, not every investor is eligible to do this. You would have to be cleared for option trading and spreads by your brokerage firm before you will be allowed to short puts. Also, it is really a good idea to have some experience trading options before trying this.