Play it Safer With Put Options

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

Problem No. 2

Even if that fluke doesn't occur, what if you have shorted a stock at $40 in the hope that it trades down to $25, and you put in a stop-loss order to "cover your short" (i.e., buy the stock back) at $45, in an effort to limit your downside to 12.5% (or five points)?

The downside here is that your stock can trade up to $45.15 -- even just briefly -- and you will have automatically bought the stock back and taken your loss. It's never fun to then see that stock trade down to $25 like you thought it would, when you don't realize the 15-point profit because you have closed out (or "covered") your short position at $45.15.

Now, let's assume again that you are willing to risk the five points if you knew that would be your MAXIMUM loss when shorting the stock. Well, when you own the right put option on the stock, you are risking about the same amount that you were willing to risk when shorting the underlying stock, but with a put you know that your maximum loss IS about five points.

Example: Suppose the stock climbs to $45 and then keeps on climbing further to $49. You can still stick with the put position, as your risk is predetermined.

As a matter of fact, chances are that if the stock traded to $49, your puts would still have some value. If the stock swings up to $49 but then drops back down to the original price of $40, you will be able to recover almost all of your original investment.

If the stock then drops to $25, you will realize your profit.

So the benefits are that you know for a FACT what you are risking (unlike when you use a stop loss order on a stock), and you may be able to profit, even if the stock swings the wrong way before heading in the direction that you wanted it to.

That brings us to Rule No. 3 ...