One Way to Bet Against the Market

Over the long run, the stock market trends upward (yes, this is still true) to reflect corporate earnings and dividend growth. But we've all been reminded in the past year that in the short run, stocks can go down -- sometimes quite sharply.

Obviously, someone profited from this recent downturn; those who bet against the market likely made out pretty well. Perhaps the biggest winner was hedge fund manager John Paulson, whose funds were up $15 billion in 2007 alone, thanks to his bets against the subprime housing bubble.

While few among us can expect to profit that handsomely from betting against the market, we do have a number of tools available to make money in a down market.

Let me "put" it to you this way
The simplest way to bet against a stock is to buy put options. To review, buying a put option gives you the right to sell a given stock at a certain price by a certain time. For that privilege, you pay a premium to the seller ("writer") of the put, who assumes the downside risk and is obligated to buy the stock from you at the predetermined price.

Got all that? OK, let's try an example to illustrate. Say you think Company XYZ is totally overvalued at $50 a share and is due for a haircut. To bet on a decline, you buy one January 2011 $40 put contract that costs $2 per share, yielding a "breakeven" price of $38 per share ($40 strike minus $2 premium paid). Since each contract represents 100 shares of the underlying stock, you now have the right to sell 100 shares of XYZ stock at $40 a share until January 2011; of course, it'll cost you $200 (plus commissions) to enter the trade.

Now fast-forward to January 2011:

If Company XYZ's stock ...

Then ...

Return

Soars to $100

Your option expires worthless, and you lose your premium of $200, but nothing else.

(100%)

Falls slightly to $44

See above -- the stock fell, but not enough to make your put profitable.

(100%)

Drops to $20

Nice! You make $1,800 ($40 strike-$20 at expiration-$2 premium paid).

800%

Goes to $0 (bankrupt)

Ideal. Your put is worth $3,800 ($40 strike-$0 at expiration-$2 premium paid).

1,800%

As you can see, when you buy puts, you risk just a little capital (in this case, $200) to control a lot of stock (100 shares per contract). This leverage allows you to reap outsized rewards if you're correct; if you're wrong, the most you'll lose is the premium paid.

The put strategy also allows you to make bearish bets against indexes and sectors by buying puts on exchange-traded funds that track them. For instance, if you're down on tech, you can buy puts on the Nasdaq-100 tracking PowerShares QQQ ETF, instantly betting against the index led by tech titans like Apple (Nasdaq: AAPL  ) , Google (Nasdaq: GOOG  ) , and Microsoft (Nasdaq: MSFT  ) .

Why not just short?
Buying puts has its advantages over outright shorting a stock -- where you borrow stock from a broker with the hope of buying it back at a lower price and keeping the difference. For one, with puts, your maximum loss is the premium you paid, whereas with a short, your potential losses are unlimited.

Another problem with shorting outright is that you can't always do it. Sometimes the stocks you want to short the most are hard to come by, and brokers can't find any shares to lend out. Additionally, the SEC can take an emergency action to prevent investors from shorting certain companies, like it did last year with financial stocks such as Goldman Sachs (NYSE: GS  ) , Bank of America (NYSE: BAC  ) , and JPMorgan Chase (NYSE: JPM  ) .

Finally, shorting a stock requires you to pay your lender dividends as they are paid, making shorting a high-yielding stock like Altria (NYSE: MO  ) a costly proposal. When you buy a put, on the other hand, you're not on the hook to pay periodic dividends, though anticipated dividend payments do affect the price of the option to some degree.

Tread carefully, Fools
Even if you think a stock is poised to plunge, remember that the stock market can be irrational in the short run, and that options have a finite life. What you consider a "sure thing" could take more time to materialize than the option affords, so be comfortable with the risks you're taking before you place the trade. 

To review: Your maximum loss when you buy a put is the premium paid, but that's still cash that you'd otherwise have in your pocket, so allocate it as carefully as you would any other investment.

In full appreciation of that risk, buying puts offers you a way to bet against stocks, indexes, and sectors without exposing your portfolio to potentially unlimited losses that you would incur by straight shorting.

Over at our Motley Fool Pro service, we're using options strategies to help us profit in all types of markets. If you'd like to learn more about what we're up to, just enter your email address in the box below to receive more information on Motley Fool Pro.

Pro analyst Todd Wenning would like to thank the good folks at Company XYZ for letting it be his punching bag for this article. He does not own shares of any company mentioned. Google is a Motley Fool Rule Breakers selection. Apple is a Motley Fool Stock Advisor recommendation. Microsoft is a Motley Fool Inside Value recommendation. The Fool's disclosure policy is renowned the world over.


Read/Post Comments (9) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 08, 2009, at 5:30 PM, Zaneyjaney wrote:

    Nice explanation on the puts and shorts. Sadly, I still have no idea how to digest what you said. Novice investor that I am, I'll stick to Stock Advisor recommendations, CAPS thoughts, and my own due diligence in predominantly small-cap stocks.

  • Report this Comment On March 10, 2010, at 7:42 PM, donrjr wrote:

    I jut thought I would add my thought right now -

    Thank you for the particles on "Options" I copied the entire set of them, will take them home and expect to learn something new from it all. I've been trading options for 15 years or so, but never find a good article that I enjoy, I always think I can learn something from it or at least recall something. So - Thank you for the articles on options.

    donr

  • Report this Comment On April 13, 2011, at 9:21 PM, dnvreldrdg wrote:

    I have never felt comfortable with options. To be honest I have always wanted to get in to commodities options whatever kind of thing. I have spent money on learning about it, I have studied, ;have followed the market, watched the weather forecast, you name it. I just can't convince myself that I know it enough though to put up the premium and risk losing it. Which is 'foolish', smiles, because I have lost just as much by trying to be a day trader too. I know from experience the best thing to do is buy into something good and stick with. I think my problem is I always feel like I need to be doing something instead of just watching. Maybe I should take up fishing.

  • Report this Comment On October 12, 2011, at 10:16 PM, counturmoni wrote:

    If you lose $100 it doesn't matter how you lose it. This article seems to suggest that losing 100% of your investment on puts is better than losing 100% on shorting. Alternatively, it might be suggesting that if you have $X to invest you will mysteriously keep most of it in cash when buying puts, but go all-in when shorting. The bottom line is shorting gives you control of when to realize a loss or gain, without an expiration date. Puts, on the other hand, are time-sensitive and much more risky, although the payoff is obviously much bigger IF you succeed.

  • Report this Comment On June 15, 2012, at 5:46 AM, scopas585 wrote:

    fees fees fees - thats what kills it

  • Report this Comment On August 29, 2014, at 1:17 PM, ltse2012 wrote:

    Theoretically it makes sense. But what really happens in real life when your long put options on a company that is bankrupt? I mean your left holding options on a company whose underlying is halted or non-existent, how then can you sell your put options? and to whom?

  • Report this Comment On September 18, 2014, at 3:46 PM, Unthink wrote:

    Using this example, the investor buying the put option is the one who owns the shares (or does the Put buyer have to own the 100 shares at all?) since a put gives him the right to sell the shares.

    And the seller of the put (the investor who doesn’t own the shares) would agree to receive the premium of the put from the buyer in hopes that the stock will actually rise, yielding a clean profit of the premium amount, correct?

    I appreciate any feedback given.

  • Report this Comment On October 13, 2014, at 4:07 AM, ilygod wrote:

    what happens to a put option if the underlying company is halted? for example, I have bought 10 put options of GTAT at the cost of 30cents. it expires on Oct 18th. if the company stops trading on Oct 15th what happens to my put option?

    thank you.

  • Report this Comment On October 13, 2014, at 4:08 AM, ilygod wrote:

    sorry, the 10 put options were at the strike price of $1. cost was 30 cents.

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