Shorts & Puts

The markets got a sober wake-up call this week, after running up with some nice corporate earnings reports. So, for the new traders out there, I thought I'd try to explain shorts and puts.

A short allows you to make money when a stock goes down. Essentially, your broker loans you the shares of a stock which you then sell. You are selling those shares at their current price because you believe the price is going to go down. When the price goes down, you then "cover your shorts", or (in a sense) return the borrowed shares to your broker. The difference in price between when you sold the stock and when you covered the short is your profit...assuming, of course, that the price did indeed go down. At some point, you have to return the borrowed shares and cover your shorts. So, if the price goes up, then you can lose money.

So, shorting stocks is essentially the reverse of buying stocks long. But many new traders have a difficult time getting their head around the concept. As a result, they don't make money while the market is going south.

Puts are a little different. Calls and puts are option plays. As options, they give you the right, not the obligation, to purchase. So, if you think the price of a stock is going to go up, then you can buy a call option. When the price goes up, you can sell that option to someone else, just as you would a stock. (Yes, I am over-simplifying.)

You can also buy a put option. A put option gives you the right to sell a stock because you believe price if going down. This is similar to shorting a stock, except you don't short an buy a put.

When the price of the stock goes down, then you can sell your put to someone else and make money.

There is more risk with options. Inherent with any option is an expiration date. At some point in time, the option expires. As such, the closer we get to the expiration date, the option becomes less valuable due to the increased risk of time limitations. An option can expire and cause your whole investment to be lost.

The benefits of options are many though. You can hold onto your long swing trades (if you think that's a good idea) and buy puts on the same stock as protection.

You can also buy puts on stocks you think will go down, accepting the risk that comes with the expiration date. For that risk, however, you can get some very sweet returns.

As some of you know, I've been using Ichimoku charts in my swing trading lately. So, on July 29th, I bought Put options on the stock XLNX (with an August expiration) for 50 cents each because the charts told me the market and this particular stock were exhibiting weakness. This week, I sold those Put contracts for $2.45 each...close to a 400% ROI in just two weeks.

In the chart above, the top circle shows when I bought the August Put contracts for XLNX. There were two critical lines of resistance...the 18 MA shown by the dashed line, and the blue line of the Tenkan-Sen. In the bottom panel, you can see how RSI had already fallen from its highs and was pointing down.

I was also looking below price, to the thin area of support provided by the Kumo.

I sold the Put contracts when price gapped down this week in the bottom circle. I decided to cash in my gains since they were high and options expire next Friday.

Now, that's unusual. So don't rush out and put all of your money into options. They are risky. And those sorts of gains over a two week period are far above normal. But I tell it to you to get your attention, to brag a little bit, and also to encourage you to explore adding shorts and puts to your mix. As always, you should study this subject a lot more before trading stocks or options since both contain elements of risk.

Hope this helps explain shorts and puts a little bit, in case you were unfamiliar with them. And I hope your trading is going well.