Why Put Options Offer You Less Downside Risk

The DOW cracked 12,700 last week for the first time ever. The NASDAQ previously broke above 2,500, but it was unable to hold. The charts suggest some near-term topping at this time despite the bullish market sentiment. Given the buying, stocks are clearly technically overbought at this time and could face some near-term selling pressure.

Now, some of you may be looking to short the market. I don’t advise this strategy for the average investor due to the enormous risk involved. Instead of shorting the market or specific stocks, I suggest you look at buying put options or initiating a bearish call spread. The major advantage of put options over shorting is that you know from the start the maximum risk you will be subject to with options.

Versus short selling, put options require less upfront money and entail far less risk. Let’s take a look at Google Inc. (NASDAQ/GOOG). To short 100 shares of Google at the current price of $471.20, the required initial margin requirement is 50% on the short position, or $70,680 (150% x $471.20 x 100 shares). This is the money you put at risk, since shorting involves unlimited risk because, in theory, the price of the stock can rise indefinitely. The greatest risk lies in momentum-driven markets.

Alternatively, let’s say you believe Google will decline by September 2007. You can buy the out-of-the-money Google September 2007 $470 Put option for a premium of about $3,590 for one contract (which equals 100 shares of Google). The $3,590 is the maximum risk.

In my view, put options represent a more prudent bearish strategy than short selling. Here’s why:

A short seller simply “borrows” a particular stock that he or she doesn’t own and sells it in the market at the prevailing price. For the strategy to pan out, the short stock must drop in price so that the short seller can buy it back at a lower price and replace the borrowed position to the registered holder. The risk is that the stock could rise in price instead of falling.

For example, let’s say you had decided to short Google. You placed a short on 100 shares at $471.20. Let’s assume the price of Google rallies to $550 by the expiry of September 21, 2007. At this price, you would have to short cover by repurchasing the 100 shares of Google at the higher $550 price in the open market and returning the shares to the holder. You would end up losing about $7,880. Compare this to the buyer of the put option who would only lose a $3,590 premium in the same scenario.

In my opinion, the limited risk of put options far outweighs the extreme losses that short selling can generate.