Traditionally, markets have gone up and markets have gone down. This is surely an understatement in terms of reality. We all know this. However, many opportunities have been presented to the trader when the emergence of a bear market sits on the horizon. In fact, the potential for larger gains is usually presented in the down market scenario. Black Monday, The Internet-Tech bubble of 1999-2000. If a trader would have had the foresight to understate basic economic theory regarding the tock market, one could have been enjoying the fruits of his labor. But alas! That was then, this is now. However, when examining an opportunity to exploit the down side of the market one traditionally utilized the concept of "shorting stock", which is selling stock that you do not own and then buying it back, at a later date, or "covering", hopefully at a cheaper price than you "shorted" the stock. For example, let's say XYZ was selling at $54 a share and you decided that it was selling at too high a price and you wanted to take advantage of the over valued price of XYZ, you could short the stock XYZ. To simplify the process of shorting, I will assume you have checked with you broker and he has the stock and that when you put in your order it was executed on a downtick or a zero downtick and you shorted XYZ at $54. Now for all of you who are not familiar with the process of shorting stock, simply put this is what happens. You sell stock you do not own, and put up the margin requirement (usually 50% of the value of the underlying stock being shorted. At this point, assuming your brokerage firm had the shares available to short, you are credited $54 for every share that you shorted. So in our case we are shorting 500 shares of XYZ at $54. So our account would look like this
Figure 1-1: Short account with credit of 500 shares of XYZ at a market value of $54.
Now after shorting the stock, several things can happen. In the stock market, as we all know, those things can be good or bad. Let's look at the best-case scenario first.
If the stock goes down, let's say to $40 a share, we could buy back the stock (or cover) at $40 and we would end up with $14 a share profit. Since we owned 400 shares that would be $14 times 400 shares or $5,600. Not a bad day's work.
Now for the second scenario. Let's assume the stock doesnt move, then you make nothing. The only thing gained or loss is the commission or transaction fees that you spend to put on the position and eventually cover it.
Now for the third scenario. XYZ just announced that they are being taken over by MNO at a price of $94 a share! Houston, we have a problem. Since you shorted 400 shares at $54 a share, you now must buy back, or cover those 400 shares, not at $54, but at $94 a share!
In the last few weeks, we have pinpointed insider buying on six stocks that have the potential to deliver stratospheric gains.
Click here for our SPECIAL REPORT on these 6 stocks insiders are buying and why you should too.
That means you must come up with the difference between the $54 you received and the $94 that you have to cover your short position. That is $16,000! That is a pretty big hit and remembers, it could have been worse had the offer been $100 or more for the takeover. As you can see shorting has significant risk factors involved in the practice. Usually, a sophisticated trader will use stops and limits to protect himself from this type of situation. Now for those of you who still believe, as I do, that there are excellent profit opportunities on the downside as well as the upside need not fear, for all is not lost. Just as an individual can use a call option instead of buying the underlying stock if he feels a stock is about to take off, as well as limiting his amount of investment risk to just the price of the call option, the short selling can do the same thing. In the short seller's case, instead of shorting the underlying security and going through that whole process of seeing if the broker has the stock in house, waiting for a up tick in the stock or zero up tick, and finally having to put up as much as 50% of the market value of the security to get in a position to profit from the stock's downward direction; the short seller could instead purchase a put option.
So why purchase a put instead of stocking the stock outright?
Answer: For the exact same reasons one would purchase a call option in anticipation of a market mover to the upside, the investor who was looking for a market move to the down side would purchase a put.
1. Less out of pocket risk, like the call buyer the most one can lose is the amount the purchased for the put option.