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 the 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 Qualcomm (Nasdaq: QCOM  ) , Gilead Sciences (NYSE: GILD  ) , and Oracle (Nasdaq: ORCL  ) .

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 US Bancorp (NYSE: USB  ) , BB&T (NYSE: BBT  ) , and Wells Fargo (NYSE: WFC  ) .

Finally, shorting a stock requires you to pay your lender dividends as they are paid, making shorting a high-yielding stock like Bristol-Myers Squibb (NYSE: BMY  ) 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 could incur by straight shorting.

To learn more about buying puts and other options strategies, please enter your email address below to receive a free instructional video series from the Fool.

This article was originally published June 8, 2009. It has been updated.

Motley Fool 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. The Fool's disclosure policy is renowned the world over.


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