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When a stock is reaching a top, what’s the best way to trade it?
Some decide to short-sell the stock. That involves borrowing shares and selling them, with the aim of buying them back at a lower price. You return the shares to the lender and get to keep the difference as profit. (If the stock keeps rising, you’ll have to buy the shares back at a higher price, taking a loss.)
But selling short is not as straightforward as it seems.
For a start, you need an account that allows you to short-sell. There are borrowing fees and other charges involved.
But the biggest issue is that your risk is undefined…
A stock can only fall to zero, so the profit on a short trade is capped. However, a stock can technically keep rising to infinity. So your losses are potentially unlimited.
That’s why many traders prefer options instead.
By using options, your risk is clearly defined. But you need to understand the strategy you’re using.
That’s what I’d like to look at today…
A Pullback Is Coming
The most common options strategy to benefit from a falling stock is to buy a put option. A put option increases in value when the underlying stock falls.
But the key here is “when the underlying stock falls”…
All options expire, and the closer the expiration gets, the more time decay eats away at the option’s value. If the move you’d anticipated doesn’t play out soon enough, you run the risk of the option expiring worthless.
Buying a put option costs you money to place the trade. But in this case, your risk is clearly defined. Your maximum loss is the amount you paid to enter the trade. So even if the trade goes wrong, your maximum loss doesn’t change.
The major criterion in deciding to buy a put option is your confidence about the timing and size of the down move. If you’re sure the stock is on the brink of a fall, then this can be a strong trade.
But what happens if the stock gets stuck in a sideways pattern, with time decay eroding the value of your option?
This is where another option strategy fits into the picture…
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A Stock Is Drifting
If you’re confident that a rally has petered out but think it’s going to drift, then a bear call spread can be a great strategy to use.
Unlike buying a put option, it’s a “credit” trade… so instead of paying to enter the trade, money goes into your account at the outset.
A bear call spread involves simultaneously selling and buying call options on a stock. Each leg has the same expiration but different strike prices.
So, for example, say a stock is trading at $500 and you don’t think it’s going to trade higher. You might sell a call option with a strike price of $510 while buying a call option with a strike price of $520.
Because the option you’re selling is closer to the current market price, you receive more for that option than you pay for the higher strike option. That’s why you receive a credit.
Again, the key factor here is that you know your risk… That’s the difference between the option strike prices ($10) multiplied by 100 (an option contract is for 100 shares)… minus the credit you received for placing the spread.
If the stock is trading below the lower strike ($510) when the spread expires, the premium is yours to keep. If you get the trade wrong and the stock keeps rallying, your risk is defined.
So the next time a rally is faltering, remember you have different strategies at your disposal. The one you use is determined by your view on where the stock’s heading next…
If you’re convinced that a stock is going to fall right away, then consider buying a put option.
If not, then consider a bear call spread strategy instead.
Both strategies can be useful tools to help you stay flexible and profit from whatever the market is showing you.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
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