Let’s say you’re bearish on a stock that’s currently trading at $70. You could buy a 70-strike put with no special rules or margin considerations to worry about. The stock drops below $70 as you predicted, let’s say to $60...
You might profit in one of two possible ways:
1. Buy the stock in the marketplace at $60, and then exercise your put. This would sell the stock at $70. These two actions would secure the difference of $10 per share, less total costs of $20.50 (commissions of $10.55 and an exercise fee of $9.95), or
2. Simply sell the put in the open market - it should be trading at a higher price than you paid to purchase it because of the downward stock move.
Of course, if the stock doesn’t drop as predicted or trades higher, you could lose the entire value of the put option - but that’s all you can lose. If the stock heads upwards, you have the right, not the obligation, to exercise and sell at $70; if you choose not to exercise your right, that’s fine too. If you no longer have a bearish opinion on the stock, you also have the right to sell your long put before you lose the entire value of your investment. Exiting your put position before it expires worthless allows you to further minimize potential losses.
What are the risks in using puts as an alternative to short selling?
Long puts as an alternative to short selling carry the same risk of any other put purchase: If the stock stays above the strike price, you can lose the entire premium upon expiration. But again, that’s the maximum amount you can lose, so your risk is capped.
If you’re thinking of short selling stocks, put buying may offer a logistically simpler, lower-cost way of acting on your bearish sentiment.
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