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Throughout my 40-year trading career, I’ve managed hundreds of other traders. And one thing stands out…
Most of them were far more comfortable on the “buy” side of the trade.
Perhaps it’s just human nature. Folks get excited about buying something new.
But it can be equally worthwhile to enter a “short” trade where you’re aiming to profit from a stock’s fall.
(This was just one of the many topics we covered earlier this week in my new podcast at www.tradingwithlarry.com. You can watch live Monday to Thursday at 8.30 a.m. ET. Catch the replays at https://www.youtube.com/@opportunistictrader.)
Until you’re comfortable trading both sides of the market, you’re limiting your trading opportunities. After all, the market doesn’t only go up.
So today, let’s look at how to profit when a stock is teetering on the edge of a fall…
Short Selling Stock
One way to capture an anticipated fall in a stock is by short selling shares. It’s a strategy that hedge funds use all the time.
For example, say you borrow shares and then sell them for $100 per share. If the price falls to $80, you buy the shares back for cheaper, return the shares to the lender, and keep the $20 difference.
But this popular strategy comes with challenges and risks.
For a start, a stock can only fall to zero. So, the potential profit is capped.
On the flip side, a stock can rise to infinity. The higher it rises, the more you have to pay to buy the shares back. So your potential loss is unlimited.
The risk/reward is asymmetrical. And a runaway rally could cause devastating losses…
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Managing Risk
That’s why, rather than shorting shares, I prefer to buy put options instead. A put option increases in value when the underlying stock falls.
Buying a put option enables me to profit from a falling stock without having to short shares.
Plus, a major benefit is that I always know my maximum risk – what I paid for the option(s).
Say I pay $300 a contract for a put option.
Even if the stock price soars, the most I can lose is that $300 per contract. That maximum loss doesn’t change – contrasting the unlimited losses of short selling shares. So you can choose your position size for the risk you feel comfortable with.
If the initial position doesn’t go your way but you’re still convinced of the trade’s thesis, you can always reenter the trade later.
Like anything, options have trade-offs…
Options expire, so you have to get the move you’re looking for relatively quickly. Otherwise, “time decay” will start eating away at your option’s value as it gets closer to expiration.
But in a market like this year’s, that trade-off can be more than worth it.
The market rallied as relations with China improved around tariffs. But this still has a long way to play out. And you can be sure that the current president in the White House will create plenty of twists and turns ahead.
So by using a simple put option strategy, you can take advantage of any future sell-offs.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
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