Over the long term, the stock market is trending higher (yes, this is still true) to reflect corporate earnings and dividend growth. But we’ve all been reminded in the past year that stocks can go down in the short term, sometimes quite sharply.
Obviously someone benefited from this recent recession; those who bet against the market probably did well. Perhaps the biggest winner was hedge fund manager John Paulson, whose funds rose $15 billion in 2007 alone, thanks to his bets against the subprime housing bubble.
While few of us can hope to make such generous profits betting against the market, we have a number of tools available to us to make money in a falling market.
Let me “put it” this way The easiest way to bet against a stock is to buy put options. To review, buying a put option gives you the right to sell a given stock at a given price at a given time. For that privilege, you pay a premium to the seller (“writer”) of the put option, who bears the downside risk and is obligated to buy the shares from you at the predetermined price.
do you have all that? ok, let’s try an example to illustrate. Suppose you believe that Company Xyz is grossly overvalued at $50 a share and is owed a haircut. To bet on the downside, you buy a $40 January 2011 put contract that costs $2 per share, giving a “break-even” price of $38 per share ($40 strike minus $2 premium paid). Since each contract represents 100 shares of the underlying stock, you now have the right to sell 100 shares of the xyz stock at $40 per share until January 2011; Of course, it will cost you $200 (plus fees) to enter the trade.
now fast forward to January 2011:
As you can see, when you buy put options, you risk only a little capital (in this case, $200) to control a large number of shares (100 shares per contract). this leverage allows you to reap huge rewards if you are correct; if you are wrong, the most you will lose is the premium paid.
The short strategy also allows you to make bearish bets against indices and sectors by buying ETFs that track them. for example, if you’re not tech-savvy, you can buy puts on the nasdaq-100 tracked powershares qqq etf, instantly betting against the index led by tech titans like apple (nasdaq: aapl), google (nasdaq: goog), and microsoft (nasdaq: msft).
Why not just sell short? Buying put options has its advantages over directly shorting a stock, where you borrow a stock from a broker with the hoping to buy it back at a lower price and keep the difference. For one thing, with puts, your maximum loss is the premium you paid, while with a short, your potential losses are unlimited.
Another problem with shortening directly is that it can’t always be done. Sometimes the stocks you most want to short are hard to come by and brokers can’t find any stock to lend. In addition, the SEC can take emergency action to prevent investors from shorting certain companies, as it did last year with financial stocks such as Goldman Sachs (NYSE: GS), Bank of america (nyse: bac) and jpmorgan chase (nyse: jpm).
Finally, shorting a stock requires you to pay your lender dividends as they are paid, which makes shorting a high-yielding stock like altria(nyse:mo ) is an expensive proposition. When you buy a put option, on the other hand, you are not required to pay periodic dividends, although early dividend payments do affect the price of the option to some extent.
Think carefully, fools Even if you think a stock is about to tank, remember that the stock market can be irrational in the short term and options have a finite life. what you consider a “sure thing” might take longer to materialize than the option offers, so be comfortable with the risks you’re taking before you trade.
To review: Your maximum loss when you buy a put option is the premium paid, but that’s still cash you’d otherwise have in your pocket, so allocate it as carefully as you would any other investment.
In full appreciation of that risk, buying put options offers you a way to bet against stocks, indices and sectors without exposing your portfolio to potentially unlimited losses that you would incur by selling outright.