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Most of us are familiar with how call options can be used to create more leverage and more profit than buying the underlying financial stock by itself. Other powerful uses for options include applying put strategies to protect yourself against unlimited loss in a position, as well as protecting a new or existing position. In fact, Put options can even be used to profit handsomely from a significant drop in the underlying financial stock, as we'll see in this week's column.

ACME is currently trading at $100/share. Lets say that over the next 6 months you believe ACME will move to $150/share. Earnings growth has been excellent; the company is signing major deals, being featured on CNBC, in the business press, etc. You are therefore very bullish on the stock and would like to participate in this imminent rise in value.

However, you only have $3,000 available cash for investment (most of your account has already been allocated to other positions). With $3,000, you can purchase 30 shares of ACME. You take a look at the 6-month Call options on ACME, and see that the 100-strike price with 6 months to expiration costs $10. Thus, one options contract, which controls 100 shares of ACME, costs $1,000.

You do an analysis on paper. Let's calculate the profits based on buying the shares of ACME, versus buying the option on ACME. Let's assume ACME will close at a price of exactly $150/share 6 months from now.

Stock: Investment: Buy 30 shares @ $100 = $3000

In 6 months, sell 30 shares @ $150 = $4,500

Profit = $4,500 - $3,000 = $1,500

Percent Return = (Profit / Investment) x 100 = (1,500 / 3,000) x 100 = 50%

Option: Investment: 1 contract of ACME 100 Call with 6 months to expiration = $1,000

In 6 months, sell options at (stock price - strike price) = (150-100) = $50/share

Each option contract controls 100 shares, thus sell 1 contract = $5,000

Profit = $5,000 - $1,000 = $4,000

Percent Return = (Profit / Investment) x 100 = (5,000 / 1,000) x 100 = 400%

Purchasing the stock returned 50%, while purchasing the Call option returned 400%! In addition, purchasing the stock yielded $1,500 profit while the option yielded $4,000! Dollar for dollar, purchasing the option on ACME created 8 times the return on ACME as compared to purchasing the stock! It only took one third the cash outlay in the option to create nearly 3 times the total dollar profit. This is why options are commonly used when upside leverage is desired.

However, be sure to take into consideration that the break-even on the option position is (strike + cost) = 100 + 10 = 110, whereas the break-even on the stock is simply the price you pay, 100. In the event that ACME drops, the stock affords you unlimited time for recovery, whereas the option expires in 6 months.

In the previous example using ACME, the maximum possible loss on the stock position was $3,000 (in the unlikely event that the stock drops to $0), whereas the maximum possible loss on the option position was $1,000. Let's take a different (fictional) scenario and work through put strategies:

MiniMe Enterprises (MINI), after a meteoric rise over the last year from $26/share to $300/share, just announced that it is re-calculating its revenues and profits for the previous year, after a review by the SEC's accounting office. It also added that revenues and profits it had recognized in the previous year would no longer be counted in the new numbers. Almost overnight, the stock lost 90% of its value, from about $300/share to $30/share!

Many people use stop losses to protect themselves in the event a stock they own starts dropping. Let's say you'd purchased 100 shares of MINI $250/share, for a total investment of $25,000, and had a stop loss on the shares at $240/share (you're willing to risk $1,000 on the trade, or so you think!). On the morning after MINI's announcement, the stock opened at about $50/share. Your stop loss does not protect you if the stock gaps down below it. If you were taken out of the position at the open at $50/share, you'd have lost $200/share, or $20,000!

Suppose, instead of buying the stock, you'd purchased a Call on MINI with 3 months to expiration, at the 250 strike price, for $25/share, or $2,500 for 1 contract. You would profit on the same number of MINI shares to the upside, at one tenth of the cash outlay. In addition, the most you can lose when you purchase calls is the premium you paid. Therefore, the most you could lose, even assuming you didn't place a stop on your option position, is $2,500, versus upwards of $20,000 with the stock position!

By definition, put options give you the right (but not the obligation) to sell a stock at an agreed-upon price, on or before an agreed-upon date.

Let's consider the 100 shares of MINI that you purchased, at a cost of $250/share. You believe in MINI's prospects for the future, and you've followed the company and its stock. You feel quite confident about your investment. Still, you don't want to take a chance with $25,000 of your hard-earned money. So, rather than place a stop loss on MINI at 240 (because you are familiar with the all-too-common situation of stop losses not being executed), you look into purchasing a Put option with 3 months to expiration, because this coincides with your desired time frame for staying in the trade.

While the 3-month 250 Call option cost $25, you notice that the 3-month Put option costs slightly less, $23, because MINI has a much stronger upward bias and is more likely to rise over the next 3 months, given it's meteoric rise over the previous year. In addition to the stock, which cost $25,000, you purchase 3 months' "insurance," in the form of the Put, for $2,300.

One month later, MINI makes its announcement and the stock collapses. Most investors are crushed…but not you! Because you were cautious and purchased the Put option to protect your position, and you now have the right to sell your 100 shares of MINI, which are worth $50/share on the open market, for $250/share, the strike price you purchased. You exercise your Put, close out the transaction and receive $25,000. You've incurred a loss on the entire stock/option transaction of just $2,300, the price you paid for the Put ("insurance"). By using a Put option to protect your position, you lost less than 10% on a stock that lost 80%. Your Put allowed you unlimited upside profits and less than 10% downside losses. This is a very intelligent way to apply put options!

Suppose you only had $25,000 to place on the trade, and you still wanted to protect your purchase?

One of the endless variations of this put strategy would be to purchase less shares of the stock and use the remaining money to purchase the Put.

Example: Purchase 80 shares of MINI @ $250/share = $20,000

Purchase 1 contract of 3-month 250 Put @ 23 = $2,300

Cash remaining = $25,000 - $20,000 - $2,300 = $2,700

One-month later, MINI collapses…At the expiration of your 3-month Put option, MINI is at 50, so you exercise the Put. Let's examine the steps in exercising the Put to see how to profit from MINI's collapse:

1. Purchase 20 additional shares of MSTR @ $50 = ($1,000)

(This is because you must have 100 shares in order to assign

100 shares when you exercise the Put)

You now have $1,700 cash left in your account.

2. Sell (1) 250 Put contract (i.e., assign shares) = $25,000

You now have $26,700 cash in your account.

It came from the fact that you had the right to sell 20 more shares at $250/share than you originally had purchased (you purchased 80 shares, but 1 contract of the Put option gives you the right to sell 100 shares). You didn't actually make money on the original 80 shares (you just received what you originally paid for them, $250/share, when you exercised the Put option), but you made money on the last 20 shares.

You purchased the last 20 shares at $50 when closing your position, and immediately sold them at $250, a $200 profit/share = $4,000 total. Subtracting the cost of the Put option (your "insurance policy,") $2,300, from the $4,000 profit yields a net gain of $1,700, which when added to the $25,000 you received from exercising the put contract totals the $26,700 that now shows in your account. In these examples, we've seen how options can be used to achieve directional leverage, provide protection in the event of a disaster, and even allow you to profit in the face of disaster!

Next time someone tells you that "options are too risky", just smile, because you know better!

Happy Trading!

Staff Writer & Options Strategist

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