Chris Rowe

Play it Safer With Put Options

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RULE NO. 2: WHEN BUYING OPTIONS, KEEP THE CASH YOU SAVE

What do you do with the remaining $16,500 out of the $20,000 that you would have used to cover your short stock? (Remember, we only used $3,500 on five put contracts at $7.)

LEAVE IT IN CASH! Consider it part of this trade … the capital that is impossible to lose (which is pretty much the case). Reserve it for when you want to trade stock again. Don't use the remainder, not even to buy other options.

Remember that you are being conservative here. What I've just suggested that you do with this one position is what you should do with each position that you play when you replace stock with options.

So what is the benefit of replacing stock with options? The benefit is simple.

Normally when you sell a stock short, you have unlimited risk. The mere fact that there is so much risk involved tends to steer investors away, keeping them from profiting from a down market.

So at this point, you may be thinking to yourself, "If I did sell a stock short, couldn't I just limit my downside by implementing a stop-loss (an agreement to close out a position -- in this case, to buy the stock back -- at a pre-determined price) with my broker?"

You could, but there are two problems with that line of thinking:  

Problem No. 1

Suppose you are betting that a $40 stock will trade lower, and you sell the stock short. And when the market closes, the company whose stock you shorted might announce that it has been acquired at a higher price, or that it landed some sort of major contract.

This could cause the stock to open up much higher when the market opens the next day. If that were to happen, you would automatically have to buy back the stock that you had shorted, at a much higher price, resulting in a giant loss.

The "stop-loss" automatically triggers once the stock has hit, or traded through, a certain pre-determined price. For example, let's say that the stock that you have shorted closed at $43 and you have a stop-loss order to buy it back if it trades at or above $45.

After the market close, the company announces some huge deal that causes the stock to open on Monday at $100. Since the opening trade on Monday is at $100, the next trade will probably be the price that you cover your short at. You've then lost $55 per share more than you thought that you were limited to losing with your $45 stop-loss!

And if you shorted the stock on margin, both you and your broker are going to have a very bad day.

When you are shorting a stock, you risk losing even more money than you had invested in the trade!