Fri Oct 6, 2006: Buying Puts for the Stock Market Crash

Option investors expecting the stock market to have a big correction in the next couple months might be interested in buying put options for downside leverage.

Unlike short-selling of stocks, the bearish strategy of buying puts offers you a strict limit to your maximum loss. No matter how high the stock might rise against you, the most you can lose is the cost of the option you purchased.

Percentage returns are also higher for put-buying than short-selling when the stock makes a sharp move down.

The highlighted lines in the table below show downside price targets where the selected put options would double and triple in value by expiration day November 17th.

For example, the Fannie Mae November 60 puts would double from their purchase cost of $320 if the stock gets down to $53.60 per share, and triple at $50.40 .

The Legg Mason November 110 puts would double from their purchase cost of $970 if the stock gets down to $90.60 per share, and triple at $80.90 .

For today's first quiz question, can you figure out how far FNM stock and LM stock would have to fall to double your money by selling short instead of buying puts? Assume an initial margin requirement of 50% to sell the stocks short.

Shorting 100 shares of FNM at $57.63 would require a margin deposit of $2881.50 or $28.82 per share (rounding up the penny) so to double your investment it would have to fall to $57.63 - $28.82 = $28.81.

In other words it would have to be cut in half.

Similarly, LM would have to be cut down from its current price of $101.25 to $50.62.

How far would they have to fall to triple your money?

For this one, the answer is the same in both cases -- zero. Unlikely to happen.

But as we have seen from the put option target prices above, using the leverage available from buying put options instead of short-selling, it is within the realm of possibility to double or triple your money in a short period of time.

Remember that if the stock does not go down as you expect, you could lose all of your money, 100% of the price you paid to buy the puts, if the stock finishes up above your strike price on expiration day.

Until next time, best of luck with your option investments!