Two Ways to Profit From Falling Stocks

By Jon Najarian

Don't sit on the sidelines and hope for better days to arrive -- make the best out of these tough times by using the options markets to make money.

To play the bearish side, you can either buy put options or write (i.e., sell or short) call options.

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Buying Puts

Just like buying a call option, purchasing a put means paying up front to enter the trade. When you initiate a long put position, you are expecting the underlying instrument to experience a drop in value, which, in turn, would result in the value of your options rising.

Buying puts carries the same benefit as buying calls -- purchasing options in general gives you rights but not obligations, and in the case of a long put, you obtain the right to sell the underlying security at the listed strike price. (By comparison, with long calls you gain the right to buy stock at the option's strike price throughout the life of the contract.)

The risk/reward scenario is similar as well, in that the most you can lose on the trade is what you invest. The worst that could happen is that the underlying instrument increases in value and makes the value of your put option go to zero.

Let's say that you purchased an XYZ 25 Put and the stock dropped to $20. You would be able to "put" shares to someone who was short the option at $25, even though the market value was $5 less than the strike price. This, minus your initial investment and commissions, serves as your profit. Remember, though, that you are not obligated to sell shares; in that case, you could sell your puts at market and collect the premium outright.

For the long stock investor, the purchase of put options against the position serves as insurance. This strategy, known as a "married put," serves as a protective floor in case the price of the underlying security drops. While the long investor's hopes for the stock are much different than the individual who simply buys a put option (without holding the stock), the put allows the long investor to sell his or her shares at the strike price if they decrease in value.

Writing Calls

On the flipside, writing calls comes with unlimited risk and limited reward.

Going short means that you collect a premium right away, as opposed to laying out cash as you do with the purchase of a put.

Your goal is the same when you short a call as when you buy a put -- to see the stock price drop in value. If the stock goes down to $20, being short an XYZ 25 Call would mean that you had correctly determined the direction of the stock, and you would be able to keep the premium you collected when you initiated the trade.

However, the risks are substantially different with short calls versus long puts.

As the short-seller, you may be obligated to take a short position in the underlying instrument if the call buyer chooses to "assign" you to sell shares at the strike price to them.

If the stock goes up to $30, the holder of your XYZ 25 Calls can buy the stock from you at $25 per share, but in order to cover that obligation, you'd need to buy shares at market price, or $30 -- $5 more than they're presently worth. Ouch!

You can make either strategy work for you and your portfolio as long as you know the risks and are prepared to take quick action if your trade starts to turn against you.

And in a market like this, if you don't have some bearish bets on the table, you're missing out on a world of opportunity.

Jon Najarian is Editor of ChangeWave Options Trader.