A safer way to take a bearish position

optionMONSTER

Stocks as a whole tend to move higher over time, but that's obviously not always the case with individual names. And we all know that they tend to fall a lot faster than they rise, and even the great ones don't go up forever. That's why there are times where being short is a good strategy.

But shorting stock is not something to take lightly, as there is unlimited risk if shares run higher. There are plenty examples of heavily shorted stocks that jump and lead to painful short squeezes. Regardless of your "intended" loss limits, that could mean the end of your short selling if not your trading altogether.

There is a good alternative--an option, if you choose--in the form of buying puts that allow you to take advantage of dropping share prices.

It should be noted that there's nothing unethical about profiting from a stock going lower. Option prices are most affected by changes in the underlying stock price and by expected volatility. And it is no great surprise that expected volatility largely hinges on actual volatility. So when a stock price drops, puts pack a double punch, profiting both from the move in the stock price and the increase in implied (expected) volatility.

Buying puts is very easy to do. They can be purchased just like any stock or any call. The maximum loss is limited to what you pay for them, unlike short selling, and you can sell them anytime.

Some people have the misconception that because there are exercise and assignment features of options that one must wait for those to occur. On the contrary, most option traders close their positions well before expiration.

Detractors of options often say that "80 percent of options expire worthless," but that is obviously misleading because most options never make it that far anyway. Option buyers almost always sell before expiration, whether they are winning or losing.

Puts can provide a protective hedge on a long-stock position, but they can also balance a portfolio when traded independently. If most of your exposure is long, then owning some outright bearish puts can give you some balance. Again, the best opportunities in buying options are when you expect a big move and increased volatility, which usually come with steep drops in the stock price. (See our Education section)

The pros do this all the time. We recently saw interesting put purchases in Groupon and Expedia . Traders (or one trader) bought out-of-the-money short-term puts that expire at the end of this week.

Hedgers usually look much further out in time. The GRPN puts were up in value this morning but are quickly falling today. The EXPE puts have been steady losers, as the trader was clearly trying to use the shorter-term "cheaper" options to take advantage of a pullback.

There are times when you want to have short exposure to a stock or the market in general. For me personally, however, I never want the unlimited risk that can accompany short selling. So puts can be  another arrow in your quiver, a way to profit from the moves in the markets that cause most traders and investors to duck for cover.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter.)


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