A common adage states, “What goes up must come down.” It’s physics, right? You can’t jump up into the air without coming down. The same is true of the stock market. Everybody loves to see stocks going up, but smart traders understand that bull markets only last so long. Every upward run comes to an end at some point, and when it does, it usually leads to a downward turn.
Downward trends in stocks are sometimes very short-lived, but they can also turn into long, extended pullbacks. Both situations offer opportunities for astute options traders to make money with puts. Look at Figure 4.1.
Figure 4.1
In March, Intuitive Surgical (ISRG) ran from $250 to $350.
However, we can see that the stock began to hit resistance at its
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high price of $350 per share. Finally, after the third sloppy bounce off of $350, the stock fell through the support offered by the upward trend, as indicated by the green line in Figure 4.1. This precipitated the consolidation the stock now finds itself in. This appears to be a good opportunity for a put play. The short-term trend to the downside established the first of May might continue. It appears that the cycles for this stock last approximately 15 days. Since ISRG is in the middle of a cycle, there are about 7-10 days left in the current cycle. The stock price is about $287.57. Support is at $275. That is a potential dollar move of $12. If ISRG breaks through resistance at
$275.00, its next resting place (support) is around $250.
One of the most powerful tools in the software is its dynamic risk graph module. Let’s use it now to illustrate the projected profit of buying a put on ISRG.
Figure 4.2
Figure 4.2 shows that we can buy a July 290 put for $24.65. That’s 100 x $24.65 for a total of $246.60 + commissions to make the trade. Since there are so many different commission structures, we will leave those out of the equation. Just know that they exist. We also set up the risk graph to show the profit curve with a 30-day time frame. That means all calculations are done at the end of 30 days. If the stock goes down, it considers it to have happened at the 30-day mark. Remember that we projected that the stock would fall from $287.57 to $275. History shows that it could happen in 15 days. We’ve given it an additional 15 days to hit that mark.
87 If the stock performs as expected and is at $275 on day 30,
we will have made about $915 on our investment of $246.60.
Of course if the stock goes nowhere, the option expires worthless.
We don’t want that to happen of course ,so we set a stop loss of roughly 30% below the purchase price of the put. Also, ISRG might fall but not to the level we expected. If it suddenly shows strength and starts back the other way, exit your trade and take your profits.
One of the things about downtrending stocks that makes them so attractive to options traders is the rate at which stocks decline in value. Think of a rollercoaster at an amusement park. Most start with a long, gradual ascent to the highest point of the ride. This can be favorably compared to the long, extended uptrends stocks often experience. What happens after all of the cars have crested the top? The entire coaster careens at insane (or exhilarating, depending on your perspective) speeds to the bottom. The same thing often happens to stocks at the end of an upward trend—after everybody has realized the upward run is over, they all try to get out at the same time, sending the stock crashing, often to amazing lows. Smart traders learn to identify, through technical analysis, when these drops are likely to occur and take corresponding short positions. Then, just like the enthusiastic rollercoaster riders hanging at the edge of that first steep descent, all they have to do is hang on and wait for the drop. Once it happens, they take their profit and look for another trade. Of course, this isn’t a foolproof strategy; sometimes a stock simply pauses in an upward trend for a period of time, and then continues its run. This is why the same approach to stop losses and money management is necessary when you trade puts as you would use in any other type of trade.
The purpose for this chapter is to help you learn to identify when a stock is about to begin or continue a downward trend and how to construct a put options trade that you can use to take advantage of it. We will also discuss methods to minimize and manage risk in put options trades.
Because stocks in downward trends often drop very quickly, trading put options is a strategy that generally doesn’t lend itself well to extended periods of time. A common mistake option traders make with puts is to try to squeeze every last bit of profit in a downward trend. Most downward trends don’t last as long as a stock’s upward trend, although they may be just as severe as
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or even more dramatic in price decline than the increase in price experienced in an upward trend. This means that you should typically plan to take quick profits when you have them. We will examine this fact in more detail later.
Many traders who first begin learning and trading options tend to gravitate towards the options trades that most closely approximate the approach they use to stock trading. In other words, if you have become familiar with buying a stock and selling later at a higher price, you will naturally lean towards trading calls. If you are already familiar and comfortable with shorting stocks, then trading puts will be an easy fit for your style. This is a good thing; the more you can replicate what you have already done successfully in the stock market, the better your chances of making money in the options market are. Even if you aren’t already familiar or comfortable with shorting stocks, however, you should still take the time to learn how to use put options to take advantage of downward trends.
Successful traders make sure they know how to trade in as many markets and environments as possible. Were you in the market in April of 2000? If so, like most people, you probably didn’t think the bull run would ever end. But the people who made money that year, and the next, were the ones who knew how to adjust when the market adjusted. Learning how to trade puts is just one way to make sure you can do exactly that. If the market in general is dropping, which does happen more frequently than many people think, the worst thing you can do with your money is to place bullish trades. Many traders in this situation simply put all of the money in cash and wait for the market to begin to go up again.
Couldn’t you do better than earn 1 to 2% interest in a money market or cash account while you’re waiting for the market to go back up? Trading put options will allow you to respond to the market and keep your money in the types of trades that market conditions dictate will be the most likely to make money.
This section only discusses trading puts as a growth strategy to take advantage of downward movements and trends. There are other approaches to put trading, such as selling puts, which emphasize income. These strategies are outside the scope of this material, but are available to explore.
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