Short sellers get a bad rap. They are often villainized by the media for “ganging up” on troubled companies or even causing market crashes.
There is little evidence to support the latter, though, and the truth is short sellers are a necessary part of the market. They help provide liquidity and keep overpriced stocks in check.
I don’t know about you, but I’m not content only making profits on the upside. There is an extraordinary amount of money to be made on the downside, especially in a market like this.
But when you short a stock, you risk an unlimited loss for a limited gain. I’m a probability guy, and I don’t like those odds.
Plus, there is a strategy for profiting when stocks fall that offers limited risk and substantial (though not quite unlimited) gains. Given that, I’m not sure why anyone would choose to short stocks.
Now, my strategy involves options, another area of the market that gets a bad rap. But unlike short selling, options — when used properly — can actually help limit your risk. Today, I want to cover how to use basic put options to profit as stocks fall. To do so, I’m going to use an actual trade I recommended.
At the beginning of May, after taking a look at the bizarre circumstances surrounding United Parcel Service’s (NYSE: UPS) most recent earnings “beat,” I warned that the stock was set to drop. Despite numerous positive headlines praising the company’s Q1 “win,” the company was suffering from declining profits and operating margins that had been deteriorating for three consecutive quarters.
All in all, the fundamental landscape and some very weak technicals both predicted that UPS likely had more pain to come before it could gain any real bullish momentum.
With shares trading a hair below $107 at the time, I anticipated a 4% drop to $103. But rather than advising traders to short UPS, I told them to purchase a put option on the stock.
A put option gives you the right (but not the obligation) to sell the underlying stock at a certain price (the strike price) at a future date (the expiration date). This allows you to enjoy the stock’s downside with less risk than shorting it outright.
Specifically, I recommended buying the $115 strike puts expiring in July for $9 per share.
Because each option contract controls 100 shares of the underlying security, the trade cost us $900. That was still much cheaper than shorting 100 shares of UPS, though, which would have cost at least $5,345 on a 50% margin.
The absolute most we could lose was the $900 cost of the option. Losses for a short seller, on the other hand, were theoretically unlimited because there’s no telling how high a stock can go. But I also advised readers to add more protection by placing a stop-loss at $4.50 ($450 for the contract), so the most we actually had at risk was $450.
The goal was for UPS to drop to $103 by expiration in July. At that price, the put option would be worth at least $12 (strike price of $115 – stock price of $103) and deliver a return of 33.3% within three months.
That was the maximum length the trade would be open, but thanks to a recently formed death cross — a very powerful technical signal that indicates a new, bearish trend — on the stock’s charts, I anticipated we’d only need a handful of weeks for shares to drift back down to my target.
My instincts were right on the nose. A few days after my recommendation, the stock started slipping lower and lower, hitting my target in just two weeks. That translates to an annualized return of 869%.
Since I began my Profit Amplifier service a few years ago, my subscribers and I have been using trades just like this to bet against stocks. It’s far safer than shorting stocks, and thanks to the power of options, our gains can be magnified much more than if we had shorted a stock.
— Jared Levy
Source: Profitable Trading