Fri Mar 16, 2007: Buying Put Options on Fannie Mae

Fannie Mae (NYSE-FNM) is a federally-sponsored corporation established to facilitate home ownership for middle and lower-income Americans. With the housing sector showing signs of weakness lately, FNM stock might be a good candidate for a bearish option strategy.

An April 55 put option on FNM can be purchased for 2.50, or $250 per contract to control 100 shares.

Let's consider how far this stock would have to drop to double our money buying the put option.

Our April 55 put would double if it reached a price of two times 2.50 = 5.00 per contract. This would happen if before expiration day (April 20th, the third Friday of the month) FNM dropped to 50 or lower.

If the stock was priced at 50, the put would be worth 5 because the put gives the owner the right to sell or "put" 100 shares of FNM to the option writer at a price of 55. Buying the stock at 50 and selling it 55 would produce a profit of 5 dollars per share.

Even if the stock didn't drop that far, you could still make a profit on a smaller decline. Of course, you could lose money if the stock didn't go down much at all, or instead went up.

If FNM dropped to 47.50 or lower we could triple our money.

Note that you don't have to wait until expiration Friday to sell your put. You can sell it at any time prior to that. One rule to remember when buying options is to consider carefully and be slow before jumping in, but be ready to make a quick decision to get out when a profit is available, before it disappears. As an option buyer, time is not on your side and you have to take profits quickly to be successful. A bird in the hand is worth two in the bush. In other words, a smaller but sure real profit available now is often wise to take rather than holding on in hopes of making a big killing. That could cause you to lose your profit, and maybe more, if the stock bounces back up quickly.

One more caution: since a possible rebound of FNM above 55 would make the put worthless, only experienced option speculators who can afford to lose their entire investment in a short period of time should be involved in this risky strategy.

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