Short Falling Stocks With Less Risk

Have you ever wanted to short a real dog of a stock but were afraid of the potential for unlimited loss? Read on to discover how buying put options can help you achieve that goal without that scary risk. You'll learn how and when to use puts, plus I'll share several ideas, one of which I believe is poised to fall fast.

Why buy puts:

• You believe a stock is ripe for a fall and want to profit if it declines.
• You want to hedge against the bullish positions in your portfolio.
• You want to protect a position in your portfolio that you're bullish on from a near-term downward move.

I'll focus on the first bullet above, but learning about put options will help you achieve all three.

Put in to profit
In a table below I'll share several put options with shares trading near their 52-week high, suggesting to investors who know these companies well that they may be priced to perfection --one misstep could cause a drop. Buying put options ("buy to open") is a great way to profit from a stock's fall while putting less of your cash at risk. You can also use puts to hedge your bullish portfolio with a few positions that should profit if the underlying stocks decline. In this guide, I'll show you how to buy puts Foolishly -- keeping your risk in check and only trading on underlying companies you know well.

The strategy at work
Simply put (ahem), buying put options is the opposite of buying calls: It gives you the right to sell -- rather than buy -- the underlying stock at a set price (the strike price) by a specified date (the expiration date). Your maximum loss with a put is limited to what you pay for the option up front (the premium).

As with shorting, buying puts earns you profits when the underlying stock drops. But buying puts involves much less risk and potentially higher reward. However, since option purchases have expiration dates that work against us, it is best to buy puts on companies you know well and that have a known downside catalyst in place that may lead to near-term underperformance.

To better understand this strategy, let's look at puts in terms of maximum profit, maximum loss, and breaking even.

Your maximum profit when buying puts
Suppose your analysis is correct, and the stock drops. The value of your puts can appreciate fast, quickly outstripping the percentage gain a typical short would earn. Remember a short-seller's maximum gain of 100% doesn't apply to the put buyer.

Your maximum loss when buying puts
I know what you're thinking: With so much more profit power than shorting a stock outright, buying put options must be much riskier, right? Fortunately, the answer is mostly no. First the bad news: A put has a firm expiration date and it experiences time decay -- a reduction in value with the passage of time. This means that put buyers can't just sit and wait around forever for our thesis to be correct.

Now the good news: Our downside is limited to the premium we paid for the option whereas shorting stock represents a theoretical unlimited loss potential. Though we are exposed to more time horizon risk by buying puts, unlike the short-seller, we haven't risked a large portion of our entire portfolio (or more). Thus, put buyers can earn much more than the 100% maximum a traditional short-seller can earn, with much less capital at risk.

Breaking even
An option strategy's break-even point is where the stock price needs to be at expiration for you to neither make nor lose any money. When you buy a put, the break-even point is the strike price minus the premium you paid. A good frame of reference here is to only buy a put option if you think the stock will at least drop far enough to achieve this break-even performance. Hopefully, you'll do much better.

Which put should I buy?
Here are a few guidelines that will help you when buying puts:

• The put should be on a business that (1) you know well, (2) you have good reason to believe is going to fall in price precipitously, and (3) has a downside catalyst that should help it achieve your fair value estimate prior to the option's expiration date.
• When choosing an expiration date, make sure to allow enough time for your downside catalyst to pan out. These things sometimes take longer than expected, so it can be wise to use options that expire as far out as possible.
• To manage your risk, start off small. Your risk is limited to the premium you pay, but if you're wrong, you will likely lose most if not all of the premium invested in most outcomes. Only purchase enough contracts to cover the same number of shares you'd be willing to short.
• When it comes to strike prices, you have two choices:
  1. Buy an in-the-money put (usually 10% to 20% above the current share price) that will cost more, but is more likely to have value remaining at expiration.
  2. Buy an out-of-the money put (with a strike price below the current share price) that will cost less, but that increases your odds of losing your whole investment if the stock doesn't fall.

*Prices as of midday March 9, 2011; all puts are January 2013 puts.
**Compares one options contract to an equivalent 100-share short.
***Represents the unlikely, yet informative scenario of the stock price falling to $0.

The bottom line on buying puts to short
Buying puts is the most direct option strategy to potentially profit on a stock you believe is ripe for a sizable decline. This is just one tool in an options investor's toolbox. If you'd like to find out more about how you can use options to boost your returns, simply enter your email address in the box below to receive Motley Fool Options' "Options Edge" 2011 guidebook.