Stocks go up, stocks go down. And while most investors are in it for the upswing, some investors are willing to bet their money on the misfortunes of a stock.
They do this by short selling – actually selling stock they don’t own, borrowing the stock to be delivered to the buyer, and then buying it back later at a lower price to return it to the lender (all of which happens through the brokerage house, to the short seller those mechanics are invisible). It’s not a strategy for the timid, or for the uninitiated.
A similar strategy that allows you to profit from the downturn of a stock is investing in put options. Puts are similar in mechanics to a call option, but instead of a contract that allows you to buy 100 shares at a given price (the call option), the put option gives you the right to sell 100 shares at a given price.
Even if you don’t own those shares. Especially if you don’t own those shares.
Putting It to The Other Guy
The word put is synonymous with sell here – you literally put the shares into the hands, willing or not, of the investor from whom you bought the contract.
Why would anyone sell you such a contract? Because you, the put option investor, will be paying them cold hard cash for it. And in figuring your potential profit, you must include your initial investment cost in the equation.
Chances are you’ll never have to sell the underlying stock at all, you’ll just sell the option contract itself on an options exchange. This avoids the mechanics of selling the stock and simultaneously having to buy it at the current market price in order to make delivery on that sale. Like short sales, this all happens behind the scenes within the scope of the brokerage house handling your account.
Running the Numbers
Let’s look at an example of a put contract in action. Let’s say you’re watching ABC company, whose stock is currently selling for $26. You think it may go down, for whatever reasons. Instead of selling short, requiring you to have 50% of the total transaction on deposit in your brokerage account, you decide to buy a put option instead.
Each contract gives you the right to sell 100 shares of the stock to the seller of the put option at a given price, called the strike price. Most optionable stocks have several available strike prices – in this case, let’s say you buy a contract with a $25 strike price.
This means that you have the right to sell 100 shares of ABC at $25, even if you don’t own it right now, and no matter what the current market price is. If the price never falls below $25, you’d either sell your contract at a loss or allow it to expire worthless. But if the price does fall below $25, the value of your put option contract will go up accordingly.
How much? That depends on the market price. If you bet correctly and the market price is now, say, $22, then your contract is $3 in the money (the $25 you’ll get for it, versus the $22 you’ll have to pay for it in order to deliver on the $25 sale).
In actuality, though, instead of exercising the option (which normally only happens at the very end of the trading window, or term) you’d simply sell the contract on an options exchange, in this case for tidy profit. If you paid $150 for the initial contract (a price of $1.5, times 100), and the selling price was, say, $4 (assuming some time remained in the term), then you’d show a $250 profit on this trade.
The Forces of Price
Pricing for puts and calls are a combination of intrinsic value (the in-the-money portion) and premium value, which is a perception of future value as determined by market demand. If the investing public believes the stock will tank even further, and if sufficient time remains on the term of the contract, chances are the premium value might be significant, even as much or more than the existing intrinsic value.
Then again, if you were wrong, if the price doesn’t go below $25 in this case, your option will gradually become worthless, right up until the moment it expires.
It’s a fast game, and not one for the uninitiated or weak of heart. The first step is to learn the ropes and watch how the market performs. After that, even with only a basic understanding, you’re on an even playing field with seasoned investors who, at the end of day, don’t really know any more about the future than you do.
