Berko: Let’s look at short selling and put options

Dear Mr. Berko: Is it possible to make money on a stock if it falls in value? Our broker has a list of nine stocks he believes will crash in the coming 12 months. He has advised my husband to put up $2,900 and buy put options on all of them. Please explain puts to me, because my husband won’t or can’t.

— EW, Springfield, Ill.

Dear EW: Yes, you can make money when a stock price falls. The term “short selling” means a bet that a stock’s price will fall.

Assume you have good reason to believe that Dumbo’s Family Diner (DFD-$100), which you don’t own, will report lower revenues and earnings and that it will drop in price. You can make money two ways. The first is to open a margin account, borrow 100 shares of DFD from your broker (you’ll need $5,000, or 50 percent of DFD’s market value, in the account as a security deposit) and then sell those shares at $100 each. This sale puts a $10,000 credit in your account that’s really not yours because you sold DFD and don’t own it. Three months later, DFD reports lower revenues and earnings, and the stock slumps to $90. Now you use $9,000 of that $10,000 credit to repurchase 100 shares of DFD at $90 and return Dumbo to the owner. You keep the remaining $1,000 as a short-term profit. Simple as Simon and easy as pie, but there are lots of moving parts while putting $5,000 at risk. And the big risk is that you were misinformed. If DFD reports great revenues and earnings and the stock rises to $110, you’re $1,000 behind the eight ball. So you repurchase 100 shares of DFD at $110 ($11,000), return DFD to the borrowing broker and then walk away with your tail between your legs. You take that $1,000 from the $5,000 deposit, leaving you with $4,000, or $1,000 poorer.

Put options are easy to use and the least risky way of short selling a stock. Puts can geometrically increase your profit potential while limiting your losses to a teeny fraction of the stock’s price. In this instance, a put option is a contract for a specific period of time, giving the owner (you) the right to sell 100 shares of DFD at $100 at any time before the time period expires. This time period is called the expiration date, and the price at which DFD may be sold is called the strike price. Each put covers 100 shares.

Here’s how it buries. Assume DFD is trading at $100. You purchase a put on DFD with a three-month expiration date and a strike price of $100, for which you will pay a $200 premium. This premium is the price paid to an investor who guarantees to buy 100 shares of DFD at $100 a share at any time during the coming three months, even if it’s worth, say, $42 a share. So instead of risking $10,000 as in the above example, you’re risking $200. Because a put is a form of shorting a stock, its market price will mimic the changes in price of DFD shares.

For illustrative purposes, assume that on the put option’s expiration date, DFD trades at $95 a share. You can buy 100 shares of DFD at $95 and use the option to sell DFD at $100 and make $500. Therefore, this put will sell for $5 on its expiration date. So sell the put at $5. Because the put cost you $200, your net profit is $300. However, if DFD is trading at $99 on its expiration date, the put will be worth $1, or $100 per contract. Sell it at $100. Seeing as you paid $200 for the contract, you’ll lose $100 on this trade. And if DFD is trading at $100 on the expiration date, your put will expire worthless and you’ll have lost the $200 you paid for the put.

Recognize that your maximum loss is $200. If you shorted DFD stock at $100 and it rose to $110, you’d be $1,000 in the red. When shorting a stock, your losses are theoretically infinite. If DFD got a $1,000-a-share buyout offer from Uncle Remus Restaurants, you’d be $90,000 deep in the briar patch.