Options: Not Just a Bunch of Bull

One of the great features of stock options is leverage. If, early this year, you had bought call options on a stock like Titanium Metals (NYSE: TIE  ) (which supplies titanium to the airline industry, among others), you would have made a good trade. But options are much more than a leveraged substitute for a bullish position on a stock. They're a great way to position yourself when you're bearish on a stock, too.

Take an old-economy automaker stock like General Motors (NYSE: GM  ) . GM and other U.S. car companies have been losing market share to Japanese automobile manufacturers such as Toyota (NYSE: TM  ) for many years now. If you had a position in GM stock during the course of 2005, you'd be telling a sad story -- unless, of course, you were on the short side! Similarly, in 2006, declining stocks like XM Satellite Radio (Nasdaq: XMSR  ) and Urban Outfitters (Nasdaq: URBN  ) have been profitable short candidates.

But simply taking a short position in a stock has its drawbacks. A big one is the margin requirement -- a collateral cushion that brokers insist on, should the trade go sour. Legally speaking, starting a short sale requires having 50% beyond the value shorted in your account, and maintaining the position requires a still-high 30% extra -- the legal minimum -- or more.

There's a good reason for the margins being so high; short-selling can be risky! If you're wrong about your short and the stock rallies, you may stand to lose a lot of money. "Stocks can go to infinity," they keep telling me. (For the record, I've never actually seen this happen.) But when a stock on a downtrend reverses course, the way Kohl's (NYSE: KSS  ) did at the beginning of this year -- from $58 in the summer of 2005 down to $43 in January of this year, and back up to $72 recently -- it behooves an investor to have a strategic plan in place to limit potential losses on any short position.

Here's where a more sophisticated trader might consider using puts. Let's say XYZ Corp. preannounces bad earnings. Investors dump the stock, and your favorite TV stock pundit says he'd rather sit through a Kevin Costner movie marathon than own it. If you think the stock has entered into a prolonged downtrend, you may consider shorting the stock to profit from the downtrend.

But not so fast -- there may be a better way. Instead of shorting the stock and having unlimited upside risk -- not to mention tying up a lot of capital to meet margin requirements -- you might consider a put option.

Let's take a real-life example. Assume, just for kicks, that you are bearish on IBM (NYSE:IBM). With IBM currently trading around $90, you could buy an April 2007 "at-the-money" $90 put option, allowing you to sell the stock to a counterparty for $90 at any time before the option expires for a $2.85 premium. (Option premiums are stated on a per-share basis. With each option contract representing 100 shares, the $2.85 premium comes out to $285 of actual cash.)

The benefit to buying the put: If your bearish forecast is wrong and the stock moves higher, there is a limit on how much money will be lost. When buying an option, the most you can lose is what you pay for it -- in this case, $2.85 per share, not including commissions. The profit potential, however, is substantial -- although despite having never seen a stock go to infinity, I have seen them go to zero. Think Enron and WorldCom.

If IBM is trading above the strike price of $90 at expiration, both the actual short and put positions are losers. But the losses on the put option are capped at $285, whereas the potential loss on the short stock is unlimited. Sounds good, right?

Well, there is a small trade-off, and it comes into play if your bearish forecast is correct and the stock is trading below $90 at expiration. Here, the short stock position is profitable at any point below $90. The put, by contrast, is not profitable until the stock falls below $87.15 -- the strike price of $90 minus the premium of $2.85. In terms of dollar return, the put will always underperform the short stock position by the amount of the option's premium. But in terms of percentage return, a 10% move lower in the stock yields only a 10% profit on the short stock, compared with more than a 100% profit in the put. That's the power of options leverage at work.

Keep in mind that this analysis assumes that the put position is held all the way until expiration. In real life, most traders take their profits and run at some point before the option expires. If the stock moves down below $90 at some point before expiration, this put could show a profit at prices between $90 and $87.15. Why? Before expiration, the option possesses a certain amount of time value in addition to its intrinsic value. For the put holder, the sooner the price drop occurs, the better.

So what's the next great play in the stock market? As we sift through a myriad of stocks to find one that we believe will have a great run-up in price, it may behoove us to search for some stocks we think are heading south. And that's no bull!

For more option-related Foolishness:

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This article by Dan Passarelli was originally published on Aug.11, 2006. It has been updated by Fool sector headJoey Khattab, who does not have positions in any of the shares mentioned. The Motley Fool has an ironcladdisclosure policy.


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