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How to get Profit from a Falling Stock

Saturday, June 23, 2007

There are several ways to profit from a falling stock, but for tonight we are going to discuss the two most basic principals, shorting stock versus buying "put" options.

If you have been with us for any length of time you know I have written many times about how to "short" a stock. Basically you are simply selling a stock now, taking in the cash for the sale, and "buying back" or covering the sale at a cheaper price. so if you "short" ABC at 60 dollars and you sold 1000 shares, you took in 60,000 dollars. Now if ABC falls to 50, and you "Cover" you are buying it back cheaper. In this case you will spend 50,000 dollars. The difference between where you sold and what you spent, 10 G's is your profit.

That really is as easy and as basic as it gets friends. Don't let all the talking heads throw you a curve ball, shorting is easy and its really no more risky than going long as long as you use stops to protect yourself. Since the market goes up and down, if you only play the long side, you are missing a lot of profit potential.

But there are problems with this approach. First you need a margin account to do it, all short sales are through margin. Second, it eats up a lot of your buying power because when you go short, you are holding that position with margin that will tie up your money.

The other play is a put option. Here again Wall Street has tried to buffalo the average investor into thinking options are for the big boys. What nonsense! Anyone can and should use call and put options as a trading strategy. The risk is limited, and the returns can be phenomenal because of the leveraging inherent in options. With a put option, you are placing a bet that the stock is going to fall. Win the bet and you will win big time. Lose the bet and just like Vegas, your loss is limited to how much you bet.

If the market is going to run up for a few weeks and then spiral back down, which way should you play? That is impossible to say, we don't know your style, your risk tolerance, your bank account balance etc. but for us it's an easy call, put options win out over shorting in a scenario like that.

By using put options we can use a relatively small amount of money to be in several "plays" and each of them could return several hundred percent returns. Look at it like this. If you short ABC at 100 and it falls to 60 fantastic! You made 40 points and 40%. But if you buy put options for 1.75 and they go to 10.00, what is the percentage there? Over 500%. And look at the cost. It's next to nothing, to get such a shot at big returns.

For our money, when the time is right, buying puts against the Dow Jones Industrials, the NASDAQ 100 and the Composite and select individual stocks that carry high P/E's will be the way to go as we feel those will be taken to the woodshed for a spanking.

Posted by FR at 11:47 PM  

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Investment in equity shares has its own risks. Sincere efforts have been made to present the right investment perspective.The information contained herein is based on analysis and up on sources that we consider reliable. I, however, do not vouch for the accuracy or the completeness thereof. This material is for personal information and I am not responsible for any loss incurred based upon it.& take no responsibility whatsoever for any financial profits or loss which may arise from the recommendations given in this blog.