Play it Safer With Put Options

Play it Safer With Put Options
by Chris Rowe 08/19/08

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!