Options: Not Just a Bunch of Bullhttp://www.fool.com/personal-finance/saving/2006/08/11/options-not-just-a-bunch-of-bull.aspx Dan Passarelli
August 11, 2006
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 -- you guessed it -- titanium (to the airline industry, among others), you would have made a good trade. But you can do much more than use options as a leveraged substitute for a bullish position on a stock. Options are a great way to position yourself when you're bearish on a stock, too.
Take an old-economy automobile 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, back up to $58 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. It works like this. 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 ) . If IBM is currently trading at $75.50, you could buy an October 2006 "at-the-money" $75 put option, allowing you to sell the stock to a counterparty for $75 at any time before the option expires for $1.80. (Option premiums are stated on a per-share basis. With each option contract representing 100 shares, the $1.80 premium comes out to $180 of actual cash). The benefit to buying the put is that 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, $1.80 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