With put options, you pay the premium so you have the right to sell the stock. So basically what we're looking for is a situation where you're going to profit off the downside. Frankly, that's the part I like best about options trading. Most folks know how to make money as stocks go up in value, but not a whole lot of folks know how to make money when stocks go down in value.

It's sort of special... Think about if you're hanging out at a Christmas party or hanging around the water cooler and everybody's talking about how much money they're making as the stocks are going up. Yeah, it is fun to be part of that crowd, But it's more fun when everybody else is drowning their sorrows with all the losses they've taken. And you just sit there quietly knowing that you made a pile of money because you knew how to bet on the downside of stocks. Options allow you to do that... with limited risk.

See, before the options market existed, the only way you could profit off the downside in a stock is by selling it short. You don't own the stock and you sell it anyway with the hopes that later on, you can buy it back at a lower price. So it's the opposite of buying low and then selling high. You sell first hoping it falls in value, and you buy it back.

Now, obviously if you just sell it without owning it and it goes up in value, you lose money. So that complicates things a little bit on the side of the shorts. But short selling used to be a very valid way to make money, and the only way to make money is if the stock market fell in value. But there were some problems with it.

See, in order to sell stocks short, you have to be able to borrow it because it doesn't exist in your account. So you have to be able to take it out of somebody else's account, borrow it from them, and turn around and sell it. The complication there is you can't get a borrow on many of the stocks that are worthwhile to sell short. There's no stock available for the brokerage firm to lend it to you. Even if you broker with the No. 1 brokerage firm in the country, they may not have a customer who has stock available for you to borrow it and be able to sell it. So you may not be able to sell it short.

And in the worst situation, you do get a chance to borrow the stock, you sell it short, and then sometime in the future the customer you borrowed the stock from now wants to sell his shares. The brokerage firm can then require you to go back in the market, buy the stock at whatever price it is – good or bad – give it back to the customer, and close out your borrow. That made it a little bit complicated to sell stocks short.

Well, the creation of put options eliminates that difficulty of betting on the short side of stocks. And it's even better to use put options on this because it limits your risk a little bit. Let me give you an example using one of the most popular stocks to short sell on the market today. A lot of very smart hedge fund managers are short. A lot of smart retail customers are short. A lot of smart institutions are short... and they're all losing their butts.

I'll give you an example. Netflix right now is trading for about $210 a share. If you wanted to bet on the downside you could sell it short. You go into the market. Hopefully your brokerage firm can find stock to borrow. You sell the stock for $210 a share and if it falls, you buy it back later at the lower price. That's one way to do it. The problem with that is obviously if Netflix goes higher. What happens if Netflix goes to $250? What happens if it goes to $260? What happens if it goes to $400 a share? You're losing a lot of money. It's a little bit difficult to deal with.

There's no limit to how much you can lose when you sell stocks short. And that's a concept that's really important to understand. There is no last number. It is theoretically possible Netflix goes to $1 million a share. It's not going to happen, but it's possible. It could. My point is, there is no last number. There is no way to limit your loss potential on a short sale of a stock.

Remember what I said about options to begin with. Options are designed to reduce risk. So in this situation, we can use put options on Netflix to reduce our risk. We're not going to have to worry about what happens if the stock goes to $400 a share because the most you can ever lose when you buy an option is the premium you pay for that option.

So Netflix at $210 a share... you think it's a good stock to sell short. Well, instead of selling the stock short and going through the trouble of borrowing, holding onto the position, and the risk of potential unlimited losses, why don't we just buy one Netflix July 210 put option? Those are currently priced around $10. Let's walk through this. We're buying a put. We're buying the right to sell the stock. We never actually have to sell the stock. We're just simply buying the right to sell the stock. We're buying one contract. One contract's good for 100 shares. So we are buying the right to sell 100 shares of Netflix any time between now and July option expiration at $210 a share.

There are three things that can happen here. The stock could go down, the stock could stay the same, or the stock could go up. Since we're talking about reducing risk, let's deal with that last one first. Let's talk about what happens if the stock goes up.

If you shorted Netflix at $210 a share, and here we are at option expiration day in July, and the stock is at $250, you've lost $40 a share. One hundred shares, that's a $4,000 hit. If you bought the right to sell Netflix at $210, remember, we're not selling Netflix at $210, we're buying the right to sell Netflix at $210. We put up $10 a contract. That's $1,000 for each contract. We put up $1,000. That's the most you could lose. The most you could ever lose when you're buying an option contract is the premium you paid for it. So we put up our $1,000. We have the right to sell 100 shares of Netflix at $210 a share. If we short the stock, unlimited losses. If we buy the put instead, the most we can lose is $1,000.

What happens if the stock actually drops? What happens if it actually goes our way? Well, think about this. Again, we've got the right to sell the stock at $210. So we have a $210 July put option for which we paid $1,000. Let's say Netflix drops to $150 by option expiration day in July. The stock's at $150. We have the right to sell it at $210. So theoretically, we can go into the market, buy it for $150 a share, immediately turn around and sell it for $210. That's 60 points.

So the minimum that put option should be trading for – if Netflix is at $150 and we have no time left to our July option – is $60. We paid $10 for it, it's now worth $60. We made 50 points per share, $5,000 a contract. That's a nice trade. Obviously if we were short the stock, we would have done pretty well since the stock fell to $150 also. The problem with it though, again, what happens on the other side? What happens with the risk side if it goes higher?

I think this is a much better trade to work out. Rather than putting up money to short the stock at $210 a share, we're putting up a small fraction of the amount – just $1,000 – for the right to short the stock at $210 a share... and we can make just as much money. Percentage-wise, we make a whole lot more. So if you did this with one contract, two contracts, maybe three, that allows you to speculate a little bit on the downside.

GM was tough to borrow at that time. I remember trying to do it. I remember Porter Stansberry, who runs Stansberry & Associates, the company that publishes my newsletters, talked about shorting GM. He thought it was a brilliant strategy to do. He recommended to subscribers to do that, but you couldn't get a borrow on the stock. You couldn't find a brokerage firm that could lend the stock to you because a lot of other smart names had already done that. So there's no stock available.

The only way that you could have profited on the demise of General Motors was to go over to the options market and buy some puts. And at the time, if I remember correctly, General Motors had September 40 puts at about $4. So you could have gotten into the market and bought the right to sell or short General Motors shares at $40 a share. It would have cost you $4. Four hundred dollars for the right to sell 100 shares of General Motors at $40 a share. General Motors did go belly-up in that timeframe and what do you pay for an option? You have the right to sell the stock for $40 and the stock is in the market now for zero.

In other words, you could go into the market, theoretically buy it for nothing, and instantaneously sell it for $40. And you say, "Well, who in their right mind would buy it for $40?" Well, it's the other side of that trade. Remember you bought the right to sell the stock at $40 a share. Whoever sold that option was obligated to buy the stock from you. Remember the four basic options strategies: You can buy a call, sell a call, buy a put, or sell a put. If you buy a put, you have the right to sell the stock.

If you're the other side of that trade and you sell a put, you have an obligation to buy the stock. And it's a contract. It's a legally binding obligation to buy that stock. So you go into the market as the owner of this put, buy the stock for nothing, turn around and sell it for $40, so each of these option contracts is now worth $40. You paid $4 for it. The market is going to value it for $40 so you actually don't ever have to go and buy the stock and turn around and sell it, you simply sell the option contract back. So what you paid $4 for is now worth $40. You've made 900% on your money. Not a bad trade, given the fact that you couldn't have gotten a short sale off on the stock in the first place.

Buying puts is an exciting thing to do. Buying puts, being able to profit as the stock market falls, is outside of the intellectual capacity of a lot of folks who participate in the markets. But think about it... the market does go up over time. But it doesn't go up every day. You have situations where stocks will rise and then stocks will correct. And if all you're ever doing is trading the upside of the stock, you're probably only trading 60% of the time. The other 40% of the time, the market is either falling or doing nothing. Well, why not take advantage of that situation and trade all the time? That's what puts allow you to do.

Let me give you another example. Let's take another overpriced stock. You've got Chipotle Mexican Grill (CMG) currently trading for about $250 a share. Now, you probably know the restaurants, nothing at all wrong with the business. But at $250 a share, CMG is trading around 75 times earnings, 15 times book value, and about 12 times sales. That's an expensive stock and those are usually the ones that are a target for short sales. Well, rather than trying to borrow this stock, sell it short, and then profit on the downside, you buy a put instead. You buy one CMG October 220 put for about $7.

Now, this is a little bit different. The stock is in the marketplace right now at $250 a share. We're buying the right to sell it for $220 any time between now and option expiration day in October. Now, I could buy the right to sell it for $250. I could buy the right to sell it for $240. I could buy the right to sell it for $230. Just depends on how much money you're willing to pay for the option. The CMG October 250 puts are about three times this price. In other words, instead of putting up $700 on this trade, I'd have to put up $2,100.

So you have to adjust your risk parameters based on what it is you're willing to pay. If you like the idea of selling the stock short at $250 thinking that it's only going to fall five, 10, or 15 points, well, it doesn't make sense to buy the 220 put option. It makes sense to be a little closer to "at-the-money" – when the strike price and the stock price are the same.

If, however, you think the stock could halve, then sometimes going a little further out of the money and putting up less allows you a better risk/reward situation. And we'll talk about this in some of the later DVDs. We'll go over strategies designed around profiting off the most optimum option premium that you can get into. Which strike price makes sense? Which month makes sense? That sort of thing.

In this example, we're just going to run through and show the profit parameters off of it. So we're buying the right to sell 100 shares of Chipotle Mexican Grill at $220 a share between now and option expiration day in October, and for that right we've paid $700. In this situation, Chipotle Grill is currently trading for $250 a share. If the stock goes up, there's really nothing to talk about. The put option's going to expire worthless. The stock goes up, it doesn't matter because we have the right to sell it for $220. You're not going to sell it for $220 if it's trading on the market for anything above that. So these options expire worthless and we would lose our $700.

Again, this is where it's important to think about risk reduction. The idea behind using puts instead of selling the stocks short is to keep your risk minimal. I don't mind spending $700. That makes sense as opposed to shorting 100 shares of stock. If you would normally think about selling 100 shares of stock short, you shouldn't be buying 10 or 15 or 20 of these. In other words, you should be over-leveraging the trade. If normally you trade in 100-share increments, buy one, maybe two, maybe three put options, if you really want to speculate. But you have no business at all trading 10 or 15 or 20 of these contracts.

If you normally trade in 1,000 share increments, you have a little more money, you have a little more capital, a little more experience, then we're talking about 10, 20, maybe 30 contracts. So you take this leverage to one, two, or three times at the most. But you're not taking whatever money you have committed to buy the stock or short the stock in this example and throwing it in the option trade. That's a disaster.

So in this situation, we reduced our risk. The most we can possibly lose is the $700 we put into the trade. If Chipotle Mexican Grill stays at $250 a share, we're still going to lose 100% of our premium because we have the right to sell it for $220. The stock's trading at $250. Nobody's going to sell it at $220. It doesn't make any sense. That option expires worthless. And in this particular situation, we could lose money on this trade even if we're right about the direction of the stock.

We bought the put because we think CMG could fall in value, but because of the put we purchased, the strike price that we have is below the current price of the stock, the stock could fall all the way from $250 all the way down to $220. We still might not make any money off the trade. Again, I'll go into further detail in a later installment of this options series.

When you're looking at buying put options, you have to look at a situation where you think the stock can fall enough in value to get you profitable on the trade. If CMG drops to $200 a share, we have the right to sell it for $220. It's currently at $200, we go into the market and we buy it for $200 a share, turn around and sell it for $220. That's 20 points. We spent $700 on it. We make 13 points, $1,300. That's the idea here. Rather than selling the stock short, we're buying put options instead. We reduce our risk, maximize our profit potential.

Now, we could have gone into the market, borrowed the stock and sold it for $55, with the hope that we would be able to buy it back later at a lower price. Instead of doing that, though, it made more sense for our subscribers to buy the April FCX April 50 puts, which were trading right around 2 points. So we spend $200 for the right to sell 100 shares of Freeport-McMoRan any time between now and option expiration day in April at $50 a share.

Now, the stock's trading at $55 and we're buying the right to sell it at $50. So it's going to take a little bit more of a down move than we typically look for in the stocks in order for this trade to be profitable. But based on certain chart patterns (we'll go over them in a different DVD) and the fact that the put option premium was cheap, it made sense for us to go ahead and take this trade.

Here's what happened with it. Freeport-McMoRan was at $55 at the time we bought the put option. Freeport's stock fell all the way down to $47 a share and it only took nine trading days.

Something very important about option trading: you never have to hold it all the way through expiration. You can buy an option any day you want to and you can sell that option any day you want to. There's always a market available for it, so just because you bought the right to sell the stock all the way out to April, you don't have to hold the puts all the way out to April. You can sell them at any time.

When Freeport fell from $55 all the way down to $47, these puts that we paid $2 for, $200 a put, went up to $5. We were able to sell them for $500 a piece. So we bought them for $2, $200 and sold them for $5, $500, and made $300 per option contract. Yes, the stock fell eight points, but because it happened so quickly after we got into the position, the options inflated as well and we were able to take a nice profit off the trade.

What I really want to point out now is how lucrative it can be to profit off the downside in stocks. Most people only think about the upside in stocks. They buy stocks and make money as they go up. They don't think about the downside. And like I said before, the market might spend two-thirds of the time going up, but it spends one-third of the time going down. If you're only trading calls or you're only buying stocks, you're only making money two-thirds of the time. If you have the ability to short or buy puts, you make money the other one-third. Why not make money all the time?

Think about it... If you bought IBM at $40 a share and now it's trading for $150 and the market crashes tomorrow, you don't want to have a situation where you give back all those profits. So if you have an extended situation, why not buy a put, which gives you the right to sell IBM? You're not buying IBM now because you bought it a long time ago. You have a nice run-up in it. The put option is used as insurance. It's kind of like buying auto insurance or homeowner's insurance or anything else. You buy it because it protects you from a disaster. You don't buy it because you expect there to be a disaster. You don't want a disaster. You like your house, you like your car, but you buy insurance so that if a disaster happens, you don't suffer financially because of it.

Well, that's what this sort of put trading is for. This is a put to hedge a position. So if you have a position in say IBM, which is currently around $160 a share, and you're worried that it's going to fall in value, why not spend a few dollars on insurance? Spend a few dollars to buy a put option that gives you the right to sell IBM at $160 a share at some time in the future. If you look at the current prices of options buying a two- or a three-month put option on IBM right now at a price of $160, it's probably going to cost you about eight points.

So you'll pay $800 and have the right to sell 100 shares of IBM at $160. Yeah, it taps into your profit a little bit if the stock goes up from here. You've got to recoup the $800 you spent on insurance. But what happens if the market collapses and the stock falls all the way down to $100? You've given up a huge amount of profit. Rather than doing that, you've bought a put option, which gives you the right to sell the stock for $160 a share. You've saved yourself a lot of profit, a lot of hassle, a lot of heartache from giving back all that profit that you took so long to earn in the first place.

So that's the idea behind put options. Put options allow you to speculate on the downside of stock, and they allow you to protect yourself in the event that a market catastrophe happens, and you want to protect your long positions. There's a good time and a bad time to buy put options. Obviously the best time to buy put options is after an extended move in the stock market where prices have gone up a little bit. They've gone up too much maybe you think and now is the right time to speculate on the downside, or to buy some insurance against your existing portfolio.

It's not tough to do, and it makes a whole lot of sense.

In the next DVD, I've got something even more special to share with you. It's a way to generate income by selling puts. It's the single-best way to generate income for your portfolio... We'll hit that next time.