For some investors, it seems counterintuitive that you can make money on a stock that goes down in price. Those folks most likely haven’t heard about options trading or if they have, never pursued it to the point of understanding.
To illustrate my point, I will show you a Put trade, specifically a Buy Put (or long Put) trade on SunEdison (NYSE:SUNE). It was a Money Calendar Sell candidate that turned out well for us. This sort of trade is particularly relevant right now, as world markets post consistent declines.
I also explain this trade in greater detail in my training video below.
First, let’s look at the latest bearish signals for SUNE as depicted in the Money Calendar:
You buy Puts when you anticipate a stock will go down in price. When you buy a Put option, you have bought the RIGHT to “Put” or sell the stock to the marketplace at a specific price (the strike price) any time before or on expiration.
Example: XYZ stock is trading at $40 and you buy a $40 Put option for $2 (this is on a one contract basis, so the cost would be $200 for the option).
Next the stock goes down to $35. You have the right to “Put” or sell the stock to the marketplace at $40 when the stock is at $35. To do that, you would have to buy the stock at $35 and then exercise your right and sell the stock at $40, resulting in a $5 gain. This gain would be offset by the cost of the option price of $2, so you would gain $3 per share.
But we do not buy options to exercise our right on the stock.
When the stock is at $35, it would result in the option being considered “In the Money” or having “Intrinsic Value.” Think of it this way: The stock is at $35 and the $40 Put means it could result in a $5 gain on the stock transaction – it’s a “built in” profit potential of $5.
That $5 will be reflected into the price of the option, because options are comprised of two components that go into their price: Intrinsic Value and Time Value.
If the option you paid $2 for is now at LEAST $5 (not including any time value to make the math/illustration easier), you have a $3 gain on the option trade. Making $3 on a $2 investment is a great return!
Here is the action I previously showed for opening the SUNE trade:
Option Action to Take:
Entry Date: July 14, 2015
Buy-to-Open: SunEdison (NASDAQ:SUNE) SUNE August 21, 2015 $30 Puts (SUNE150821P00030000) at $2.75 or less.
Take a look at the chart below and you will see the boxed in price move that took place for this trade.
Because the stock went up in price on the entry date, the option pricing for the Put came down a bit, so the fill price was much better than the $2.75 limit.
The price for the fill on this trade was $1.40. One contract is the right to 100 shares of stock, so the cost per contract would be $140.
Take a look at the chart now to see what happened during the seven trading days this trade played out and you will see the stock did indeed drop enough for the option price to double.
Profit Taking Option:
Sell-to-Close SUNE August 21, 2015 $30 Puts (SUNE150821P00030000) at $2.80, (since the fill was at $1.40) or better for a 100% return or
Exit Date: Market close August 21, 2015
SUNE dropped in price, to the point that on Wednesday, July 22 the option doubled. To reiterate: this profitable action occurred in only seven trading days!
I elaborate on all of this information, step-by-step, in the embedded training video:
Learning that you can make money on a stock that goes down in price is for some a great revelation. Once it sinks in and they accept the fact, they can make money from it! It’s an important lesson to grasp, especially in today’s uncertain market conditions.