Short sellers get a bad rap. They are often villainized by the media for “ganging up” on troubled companies or even causing market crashes.
There is little evidence to support the latter, though, and the truth is short sellers are a necessary part of the market. They help provide liquidity and keep overpriced stocks in check.
There is an extraordinary amount of money to be made on the downside.
But when you short a stock, you risk an unlimited loss for a limited gain.
I’m a probability guy, and I don’t like that risk profile.
Plus, there is a strategy for profiting when stocks fall that offers limited risk and substantial (though not quite unlimited) gains.
Given that, I’m not sure why anyone would choose to short stocks.
Now, my strategy involves options, another area of the market that gets a bad rap. But unlike short selling, options — when used properly — can actually help limit your risk.
Today, I want to cover how to use basic put options to profit as stocks fall. To do so, I’m going to use an actual trade I recommended.
In December, I noticed the euro looking relatively weak against the U.S. dollar, due to a confluence of factors here and abroad. The picture in the United States was looking rosier, while things only got cloudier for Europe. I saw an attractive opportunity in the CurrencyShares Euro ETF (NYSE: FXE), which tracks the value of the euro against the dollar: As the euro’s value decreased, so would FXE’s.
Shares of FXE were trading at $103.65, but I expected them to drop below $102 in short order. But rather than advising traders to short FXE, I recommended a put option on the ETF.
A put option gives you the right (but not the obligation) to sell the underlying stock at a certain price (the strike price) at a future date (the expiration date). This allows you to enjoy the stock’s downside with less risk than shorting it outright.
Specifically, I recommended buying the $106 strike puts expiring in January for $3.40 or less.
Because each option contract controls 100 shares of the underlying security, the trade cost us $340. That was still much cheaper than shorting 100 shares of FXE, though, which would have cost just under $5,200 on a 50% margin.
The absolute most we could lose was the $340 cost of the option. Losses for a short seller, on the other hand, were theoretically unlimited because there’s no telling how high a stock can go.
The goal was for FXE to drop to $102 by expiration in January. At that price, the put option would be worth at least $4 (strike price of $106 – stock price of $102) and deliver a return of 17.6% in less than two months.
That was the maximum length the trade would be open, but I anticipated we’d be out quickly as FXE fell on news of economic weakness in Europe.
And that’s exactly what happened. Just 13 days after my recommendation, FXE dropped below my target, giving us an annualized return of 655%.
– Jared Levy
Sponsored Link: And, no, that kind of return isn’t an outlier — in fact, it’s an accurate indication of the kinds of profits you can make using this strategy. Since I began my Profit Amplifier service one year ago, the average put option trade has been open for just 29 days and returned an annualized gain of 670%.
If you’ve ever considered using options, my strategy may be of interest to you. I use it to trade both put and call options, allowing me to make money whether stocks go up or down. I actually developed it when I was 16, and by the time I was 18, I was making $600,000 a year with it.
I’ve honed it over the years and it went on to make me millions. But after a life-altering event, I decided to leave Wall Street and start sharing it with average traders.
If you’re interested in learning how it works or seeing more of my trade recommendations, follow this link.
Source: Profitable Trading