Stock Options Trading, Put Options Safer Than Shorting Stock

In order to show you how using put options for speculation purposes I first want to quickly review how to short stock. Once you see the risks involved in shorting stock I will show you how you could limit your risk using put options the same basic way. Notice I said limit your risks, when investing you need to realize there is always some risk involved. In the following examples I am using ABC stock as a fictional stock that doesn't exist for illustrative purposes only.

How to Short Stock

I am going to walk you through step by step how you would traditionally short stock hoping the market moves in your favor. In this example here ABC stock is currently worth $45. You believe it will drop by $10 to $35 or possibly even more. I am just throwing out even dollar amounts so you can visually see how it works. What would you do?

The first step for shorting stock would be to borrow ABC stock from your broker. There would be some restrictions your broker may place on this type of a transaction. The next step would be to immediately sell the stock for its current value of $45. No realize you are selling borrowed stock, this does carry with it some risks. Then you simply wait for the stock to begin dropping in price.

For this example you got lucky and the stock did indeed drop from $45 to $35 as you had hoped. In this instance then you would immediately buy back the stock for $35 dollars and return the stock back over to your broker. You would then get to keep the $10, minus commissions charged by your broker. Because options are allotted in 100 share increments we are going to say for this example that you had borrowed 100 shares. So you made a nice $1000 profit minus commissions.

This carries some big time risks. Because remember you borrowed the stock that you sold to someone else. What happens if the stock goes up by $5 instead of down in value? Eventually you are going to have to return the stock to its original owner. You will have to purchase the stock back at the higher price of $50 just to return the stock and you will have lost $500 plus commissions. But, because stocks can be volatile, what if the price of the stock goes up by $10, $15, or even $20? Your risk when doing this can be unlimited.

Using the Put Option Instead

Now let me illustrate how you can do the same type of thing will less risk by using a put option instead. What is the first step? Well the first thing that we would do is go and look at the different put options for ABC stock. For this example we are going to purchase a put option that doesn't expire for 60 days. The strike price for the option is going to be $40 and the premium is going to be $1 per share for a total of $100 per contract.

Let's say, for this example, within 30 days the stock price on the option drops to $35 like we were hoping. You then turn around and sell the put option contract for at least $5, because it has at least that much intrinsic value, so you collect a total of $500. After subtracting the $100 premium you would have made a total of $400 minus commissions. If you don't know what intrinsic value is you can either Google the term or look it up online. For right now just realize because you have a put option which gives the holder of that option the right to sell this stock for $40 and right now the stock on the market can only be traded for $35 this option has at least $5 worth of value in it.

The other advantage to this strategy is that if the value of the stock goes up you will only lose the $100 premium you paid for the put option contract. You know how much you have at risk going into the deal. Remember, it's unlimited risk if you short the stock.

I want to point one thing out to you as well. What if you felt like you could risk up to $500 on this deal. You could simply purchase 5 contracts which would cost you $500. If the stock drops to $35 like we hoped you would have made $2000 because you have to subtract the premium from the put option and commissions. Remember that when you shorted the stock you would have only made $1000 if the price had dropped to $35 and you had unlimited risk. Here you could make $2000 and your total risk would only be $500. That I believe is pretty cool. That is the power of stock options trading.