by Fred Fuld III
Did you know that one of the safest ways to invest in a stock or trade a stock is to short a put? But wait a minute, you may ask. Doesn’t shorting mean unlimited risk? Yes, if you short a stock, no if you short a put.
Let’s get some terminology out of the way.
When you short something, you sell it even though you don’t own it, hoping that it will drop in price so that you can buy it back at that lower level to lock in your profit. However, if the price of that investment goes up, you lose money on your trade.
Stock options are the right to buy or sell a stock at a particular price within a specific amount of time. A call is the right to buy and a put is the right to sell. The buyer of the put expects the stock to drop in value so that he can buy the stock at a lower price, and put it to you at a higher price (or just sell the put at a profit).
The investor who shorts a put hopes that the price of the stock either stays the same or goes up, causing the put to become worthless and giving a profit of the amount the put was sold for.
So why would someone short a put instead of just buying the stock?
Let’s look at an example. Assume a stock is currently trading for $50 a share and the put option with a strike price of 50 (the price the put can be exercised at) is trading for 2, with 45 days to go. That means it is trading at $200 for the right to sell 100 shares of the stock at $50 per share.
The buyer of the put hopes that the stock will tank. So if the stock drops to 40, the intrinsic value of the put is 10, giving the put buyer a profit of 8, or $800.
So let’s look at the seller of the put.
If the stock stays at 50 by the expiration date, the put becomes worthless and the put seller makes $200. If the stock is above 50 at expiration, the put seller still makes $200. If the stock is at 48 after the 45 day period, the put seller breaks even. And if the stock does drop to 40, the put seller is out $800.
However, suppose the seller of the put, who is bullish on the stock, just buys 100 shares of the stock instead. If the stock dropped to 40 from 50 over that time frame, the buyer would be out $1,000 instead of $800.
Therefore by selling the put instead of buying the stock, you reduce your risk by the amount you sell the put for. There are some traders who continue to sell puts on the same stocks every two or three months over long periods of time.
When would you not want to sell puts?
If the puts are rarely traded and the spread on them, the amount between the bid and asked prices (what you can buy and sell the put for), is very wide, then it may not be worth it to short the put.
If the stock pays a high dividend and you are interested in owning the company for the dividend, then it’s probably not worth selling the puts on it.
If you are concerned about missing out on the opportunity cost of the stock going significantly higher in the time frame, then you are better off buying the stock instead of shorting the puts. In the same example, if the stock goes to 60, the seller of the put still gets $200, however the owner of 100 shares of stock will make $1,000.
So before you buy your next stock for a swing trade, you may want to check out the puts to see if they are worth shorting.