This week we return to our strategy spotlight series. We’re previously highlighted the merits of everything from long calls and bull call spreads to naked puts and covered calls. Today it’s time we show some love to the long put.

He’s simple and straightforward, but packs a powerful, profit-giving punch when stock prices sour.

When budding traders first learn of stock trading they’re taught the concept of selling shares short. It’s a prime way to bank on falling prices, but carries two notable hurdles. First, your risk is theoretically unlimited because stock prices can rise to infinity. And, second, it’s expensive since your broker requires a hefty amount of collateral to cover the outsized risk.

Due to the former hurdle you’re unable to short stocks in a retirement account. Fortunately, buying puts provides a limited risk alternative. Just so you’re square on the numbers, the risk is capped at the initial put cost and the reward is essentially unlimited until the stock falls to zero.

Here’s the basic definition of a put:

A put option is a contract that gives the buyer the right, but not the obligation, to sell shares of stock at a specific price on or before a specific date.

Locking the right to sell a $100 stock at, say, $105 becomes increasingly attractive as the stock falls to $95, $90, and below. That’s why put options rise in value as stock prices slide. To be clear, when buying a put the game is still one of buying low and selling high. We’re trying to buy a put for, say, $2 in hopes of selling it later for $3 or $4 or more!

Here’s a quick example using TLT which finds itself flashing a potential bear retracement pattern:

With the stock trading at $118.63 we could buy an April $120 put for $2.74. That means we have the right to sell 100 shares of TLT at $120 up until April expiration. Because the put currently locks-in the right to sell the stock at a $1.37 premium, we would say it’s $1.37 in-the-money. If after buying the put TLT falls to $117 or $116, then the option will increase in value allowing us to sell it at a profit.

Check out the risk graph shown below:

The key to making money with puts is timing, pure and simple. If you’re not a good market timer then you will struggle scoring consistent profits with this strategy. Because the price of a put moves swiftly you can make (or lose) money much quicker than any other stock or options strategy. That means it’s challenging to minimize the damage when a long put trades goes awry. A well-placed stop loss usually still causes you to lose 30% to 40% of the put cost.

To offset these losers you either have to have a very high win rate (upwards of 70%), or you have to successfully milk your winners to generate big-league gains.