The second most common form of option investing is buying PUTS on a stock you expect to go down.
When an investor buys an option he is said to be "long" the option. The same is true when you buy stock, you are said to be long the stock. If you buy a put you are expecting the stock to go lower. This is the same strategy as shorting the stock only your risk is significantly less.
When you short a stock your risk is unlimited. The company could be acquired for a huge premium and the stock could gap open 30-50% even 75% the next day. You would have no chance to cover that short position without a loss. If it was a biotech stock, the company could announce after the market close that it had found a cure for cancer or Alzheimer's. The stock could double or triple at the open the next day.
When you are "long" a put option you are "short" the stock but your risk is limited to the premium you paid for the put, which would normally be $2-$3 unless you are speculating on some stock with a high price or high volatility.
Assume you thought Wynn Resorts (WYNN) was going lower because of problems in Macau. You believe it will break support at $100 and trade significantly lower.
In August, you could have bought the November $95 put for $4.00. That is your maximum risk on the trade or $400 per contract.
Had you made that trade you would have been short WYNN from August through expiration on November 20th. Of course, you do not have to hold the position that long but that is YOUR option. You control the holding period.
Fast forward to October 1st and WYNN has fallen to $52. Your $4 November option is now worth $42.55 and there is still over a month to go.
If you are like most traders you would not have held the option as it rose in value over those two months. When the option price doubled or tripled, you would have bailed on the position, taken your profit and been very happy with the trade.
One of the keys to option trading is to not let your profits evaporate. Noted investor Peter Lynch said one of the hardest things investors do is taking profits. They sell the winners to capture profits but keep the losers in hopes of a reversal. He said "investors should cut the weeds but let the flowers grow."
One way to do this is by rotating your position. Assume you had the trade described above. When a sufficient time has passed and the option has appreciated, you can either sell one half and keep the rest for further appreciation or rotate your position.
Assume your put had increased from $4 to $16 or a 300% profit. You could sell that entire position and then buy another option $4 put slightly out of the money and do it again. You have taken all your profit off the table and you are still only risking $4.
The downside to this strategy is that you are giving up the difference in stock movement from the point where you sold and the strike of the new put. Let's say you sold the original position at $80 and bought a new $75 put. You have given up the $5 difference between $80 and $75 plus the amount of your premium.
In the first example by the time WYNN shares had declined from $100 to $80 the delta on the option was almost 100%. That means for every $1 decline in WYNN your option premium rose almost $1 in response. The time premium had been erased and you were fully "in the money" and were appreciating dollar for dollar with every move lower in WYNN.
The catch here is that WYNN had to continue lower for that to work in your favor. If WYNN rebounded you would have lost dollar for dollar for every move higher. This is a double-edged sword but a position I like to hold.
The positive side of the new position is that your $1,200 in profit is in the account and can be used for other plays. You could launch three new plays on different stocks using options costing $4 each while you still have a long put on WYNN.
Since WYNN continued lower below $60 your new $4 option would have appreciated to $16 again and you got to repeat the process all over again. You added another $1,200 to your account and you could have purchased another put on WYNN at $45.
Normally I would not recommend continuing to double dip on a single stock because eventually it will bottom. That would be like betting "red" on a roulette table on every spin. You may get lucky multiple spins in a row but eventually "black" or "green" will appear.
Fortunately investing is a lot more favorable than roulette or craps. We have the ability to study the charts, read the news and watch the earnings reports of both the company we are considering plus the other companies in the same sector. As long as the story and the chart continues to work against the company I would continue to remain bearish on that company.
Just remember that stocks do not go up or down forever. Eventually it will become cheap enough that institutions and investors will begin to bet on a rebound and the decline will stop.
Stocks tend to go down faster than they go up. However, when a stock is declining all the officers at the company are trying to reverse that decline. All the brokers that previously were bullish on that company are reiterating their bullish calls and price targets. Institutions heavily invested in the stock are trying to decide when to buy more.
Declining stocks are subject to routine short squeezes. Declining stocks attract additional short sellers and that is fine as long as the news continues to be bearish. Just remember the rest of the investing world is hoping the stock rebounds and they are acting accordingly.
I would always use a stop loss on a long put position to protect your premium because the reversals can be violent and come on the slightest bit of positive news.
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