With the bull market now two years old and counting, many investors have finally convinced themselves that it's safe to get back into stocks. Contrarians, on the other hand, are wondering whether the best of the bull isn't already behind us, and they're starting to prepare for the next downward move for the market. But given how risky it can be to sell stocks short, you might want to look at an alternative to short-selling: buying put options.
The other side of the coin
Over the past couple of days, I've taken a look at various ways investors use options to implement investing strategies. So far, the strategies have involved call options, which give their holders the right to buy stock at a given price within a specified timeframe. Buying calls lets you bet on a rally without losing a fortune if you're wrong, while covered call strategies involving selling call options to collect valuable option premiums from call buyers.
Another type of option has its own strategies. Put options give their owners the right to sell stock, again at a price and within a period of time defined by the option's specific terms.
Although puts and calls are similar in many respects, they have many traits that are the opposite of each other. For instance, put options become more valuable when the underlying stock loses value, whereas calls would fall in price if the shares dropped. In simplest terms, put buyers are betting against a stock, while call buyers are betting on a stock's further upside.
Go short without losing your shirt
One obvious way you can use put options is to profit from drops in particular stocks. You pay a premium to buy a put option and then wait to see how the future develops. If the stock price falls below the strike price specified in the option, then you'll exercise the put and receive more money than you'd receive selling shares on the open market. If the stock price jumps sharply, then your option will expire worthless.
Again, though, put options have benefits over simply selling stock short. In the previous example, a short seller might have suffered substantial losses from a big gain in share prices. But the put option buyer's losses are limited to the amount premium paid. That's a risk-reducing feature that makes put options more attractive to some investors than regular short-selling.
Another potential use is to protect against losses on a stock you own but don't want to sell. Buying a put option hedges your risk; if your stock drops, the put option's value will go up to compensate.
The price of put protection
To illustrate how put options work, let's take a look at some of the least-liked stocks available. To find some good candidates, I enlisted the help of Motley Fool CAPS, searching for bottom-rated one-star stocks that had failed to see any stock gains during the past year. Here are the stocks, along with prices for representative put options:
Delta Air Lines
Sources: Motley Fool CAPS, Yahoo! Finance. Prices as of March 9.
As you can see, buying puts either for protection or as a way to bet on falling prices can get expensive. You'll often pay 5% to 10% or more of the stock's price to buy put options that last only a few months. You can find cheaper puts if you're willing to accept a lower strike price, but even so, you really can't afford to use puts as a permanent hedge on your stock portfolio.
Nevertheless, put options are useful for short-term strategies. And given the variety of problems the above stocks have faced -- ranging from higher energy costs for Delta, to adverse economic conditions that have plagued not only banks like First Horizon, TFS, and Credit Suisse, but also homebuilder DR Horton -- they could easily see further stock losses. In that case, owning puts could potentially prove quite lucrative.
Put on your happy face
Buying puts can help protect your portfolio against losses, even though it carries a hefty price tag. But you can also use puts when you're bullish on a stock. We'll wrap up our week of options coverage tomorrow with a look at writing put options.
To learn even more about options, be sure to check out our Options Center. You'll find a tutorial on options and much more.
If you're interested in following any of these stocks as a potential short candidate, add them to your watchlist. Don't have one? Sign up now and get immediate access to a new special report, "6 Stocks to Watch from David and Tom Gardner." Click here to get started.
Fool contributor Dan Caplinger doesn't overpay for protection. He doesn't own shares of companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't sell you short.