For years after the 2008 financial crisis, the stock market climbed to unprecedented heights, rewarding investors who had the courage to buy stocks when no one else wanted them. Yet although bull-market investors might have forgotten just how painful the 2008 recession and market meltdown was, stock markets do sometimes go down for extended periods of time. When they do, many people lose a lot of money -- but some opportunistic investors use lesser-known ways to bet against stocks to generate profits amid market mayhem. One of the easiest methods involves buying put options, which are specifically designed to help you make money when a stock or market index falls.
How put options put you on top of a falling market
Many investors get intimidated by anything having to do with options, but put-buying strategies are actually quite simple. When you buy a put option, you obtain the right to sell shares of a particular stock or ETF at a specific price between now and the date on which the option expires. In exchange, the investor who sells you the option receives the payment you make, and no matter whether you decide to exercise the option or not, the seller gets to keep that payment.
Put options leave the ball in your court when it comes to actually exercising them. In general, if the stock price falls below the specified price in the option -- referred to in the options industry as the "strike price" -- then it'll behoove you to exercise the option, because you'll be able to get more from the option seller than you would on the open market. Conversely, if the stock hasn't fallen below that level, then exercising the option doesn't make sense, because you'd get more simply by selling the shares on the exchange in normal trading.
As an example, say you came into 2015 thinking the S&P 500 (SNPINDEX:^GSPC) was poised to drop, and you own 100 shares of the SPDR S&P 500 ETF (NYSEMKT:SPY). With shares trading at around $205, you could buy an April put option with a strike price of $200 for about $5 per share, or $500 for a 100-share lot.
Between now and April, here's what could happen, and what effect it would have on your option:
- If the SPDR ETF climbs between now and April, your option would expire worthless. You'd lose the entire $500.
- Say the market falls only slightly, with the SPDR ETF declining from $205 to $201. Even though you bet against the market, your option would still not be worth anything, because the market didn't fall enough.
- If the SPDR ETF declines to $180, then your option would be worth $20 per share or $2,000. You could either exercise it and collect the full $200 per share for your ETF shares, or you could just sell the option and reap your $1,500 profit -- $2,000 in proceeds less the $500 you originally paid.
- If the SPDR ETF crashes all the way to $150, then your put option would be worth 10 times what you paid for it, and you'd have a $4,500 profit.
As you can see, buying a put option has a fixed downside, but much larger upside when the market moves your way. That introduces risk, but it can also be very attractive to some investors.
There are other ways to bet against the market, such as selling shares short or buying inverse ETFs. But ETFs that follow inverse strategies are often costly from an expense perspective. Some brokers don't allow you to sell stock short, especially in certain types of accounts like IRAs. Even if you can sell short, it can involve borrowing costs and having to reimburse the person from whom you borrow shares for dividends that the stock pays out.
What to watch out for
As useful as put options can be, they come with risks. You can lose every penny you pay for a put option, so you have to be prepared for total losses if the market doesn't move the way you expect.
Moreover, options are very time-sensitive. Not only do you have to be right that the market or a particular stock is going to drop, but you also have to know when it's going to drop, and buy an option with the appropriate expiration date. Long-dated options are more expensive, but if you buy an option with an expiration date that's too short, you run the risk of being right about the stock's price needing to fall, but wrong about when it actually happens.
As long as you're aware of these risks, put options can be a great way to bet against the market. By giving you a way to profit from downward movements without putting huge amounts of capital at risk, put options are worth exploring for your portfolio.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.