By: Chris Rowe — September 18, 2019
Many professional traders, stockbrokers, hedge fund managers and individual investors find it difficult to go negative on the market.
However, folks who make money are the ones who realize that the market can trade both up and down, and they act on it.
After all, even in an up trending market, like the one we're in now... it's possible to make money on dips and short-lived downturns.
So how do you profit from a market that may be heading south?
First, you reduce your exposure by selling part of your long portfolio. Second, you can short stocks or buy "in the money" put option contracts.
The put option contract gives you the right to sell your stock at a designated price by a designated date.
But most of the time people don't actually use the put option contract to sell stock at the designated price. Instead, they typically sell it to someone else without any stock transaction taking place.
This is similar to the way a futures contract is traded. A futures contract represents someone's intent to buy sugar, for example. If the price of sugar goes up, the investor would most likely sell the futures contract at a profit, rather than using the futures contract to buy a truckload of sugar and then trying to sell it to the local grocery store.
Most people will tell you that trading options is a very risky strategy. Well, that all depends on how you approach the strategy. I actually use options to control and reduce my risk.
When you sell a stock short, you have unlimited risk. In fact, you can lose more money than you had invested in the trade! The mere fact that there is that much risk involved tends to steer investors away, keeping them from profiting in a down market.
You may be thinking to yourself, "Couldn't I just limit my downside by implementing a "stop loss," (an agreement to close out a position, in this case, buy the stock back, at a pre-determined price) with my broker?" You could, but there are two problems with that line of thinking:
The "stop-loss" automatically triggers once the stock hits, or trades through a certain pre-determined price. For example: Let's say that the stock that you have shorted closed at $43.00 and you have a stop-loss order to buy it back if it trades at or above $45.00. However, after the close the company announce some huge deal that causes the stock to open on Monday at $100.00.
Since the opening trade on Monday is at $100.00, the next trade will probably be the price at which you cover your short. You've then lost $55.00/share... more than you thought that you were limited to losing!
And if you shorted the stock on margin, both you and your broker are going to have a very bad day.
Even if that fluke doesn't occur, what if you have shorted a stock at $40.00 in the hope that it trades down to $25.00, and you put in a stop loss order to "cover your short" (buy the stock back) at $45.00, in an effort to limit your downside to 12.50%?
The downside here is that your stock can trade up to $45.15 and you will have automatically bought the stock back and taken your loss. It's never fun to then watch the stock trade down to $25.00 like you thought it would, when you don't realize the 15-point profit because you have closed out (or "covered") your short position at $45.15.
Now let's assume that you are willing to risk the 5 points ($5.00/share) if you knew that would be your MAXIMUM loss when shorting the stock.
Well, when you own the right put option on the stock, you're risking about the same amount that you were willing to risk when shorting the underlying stock, but with a put you know that your maximum loss is about 5 points.
Example: Suppose the stock climbs to $45.00 and then keeps on climbing further to $49.00. You can still stick with the put position as your risk is predetermined. As a matter of fact, chances are that if the stock traded to $49.00, your puts would still have some value.
If the stock swings up to $49.00 but then drops down to the original price of $40.00 again, you will be able to recover almost all of your original investment. If the stock then swings down to $25.00, you will realize your profit.
So the benefits are that you know for a FACT what you are risking (unlike when you use a stop loss order on a stock,) and you may be able to profit, even if the stock swings the wrong way before heading in the direction you wanted it to.
Once you are familiar and comfortable with buying put options, it could help preserve your portfolio in a down market, with far less risk than short selling stock.
In a future article, I'll share three rules on how to identify the right put options for your stocks.