Have you ever found yourself wishing you had a time machine so you could go back and short the market at some point in time, like in 2007, knowing then what you know now?

If so, then you’re not alone. We’ve all been there at some point.

My colleague Jim Pearce was on the front lines during the dot-com bubble and its subsequent burst. Same goes for the 2008 financial collapse as well. And he not only survived both events, but prospered.

And right now, he’s growing concerned about the number of “zombie” companies on the market. According to Jim, these companies are only being kept alive by two things: the Fed’s massive, unprecedented liquidity program; and the irrational exuberance of investors.

And that can mean only one thing… these stocks are due for a massive tumble.

The good news is that we have the chance to not only protect ourselves, but even profit handsomely from it. But instead of shorting these stocks, which can be quite risky, we’ll do it in a much safer and effective way — by using put options.

Buying Puts 101

If you want to be a well-rounded investor, it’s a good idea to understand how options work. And with the risky situation developing with these “zombie” companies, understanding how buying puts is a better way to short stocks is absolutely crucial.

If you’re completely new to buying put options, that’s okay. They’re one of the most basic and common of all options strategies.

Puts are commonly used as a substitution for shorting stock. But with options, we have the opportunity to preserve our trading capital by risking less money upfront, while also amplifying our potential profits.

You see, put options go up in value when the underlying security drops. Technically speaking, a put is an option contract that gives the owner the right, but not the obligation, to sell 100 shares of stock at a specified price (the strike price) at any time before a specific date (the expiration date). When the price of the underlying stock falls, the price of the put option goes up. Usually, you’re simply looking to sell the put for more than what you bought it for.

As a substitute for shorting, we like using in-the-money options, as they will closely mimic the stock.

Example: Making Put Options Work For You

Before I continue, keep in mind this is a purely hypothetical example. But let’s say shares of company ABC are currently trading at $100. An investor then purchases one put option contract on ABC with a $100 strike price at a premium of $2.

The premium is the price you’re paying for the right to sell 100 ABC shares for $100 each. But rather than costing us $10,000, like it would in the open market, we’re only paying $200 (100 shares x $2 = $200).

Investors generally buy puts on stocks they expect to move lower. Here’s what will happen to the value of this put option under a variety of different scenarios:

When the option expires, ABC is trading at $95.
The put option gives the buyer the right to sell shares of ABC at $100 per share. In this scenario, the buyer could purchase shares on the open market for $95, then immediately use the option to sell those shares at $100. Because of this, the option will sell for $5 on the expiration date.

Since each option represents an interest in 100 underlying shares, this will amount to a total sale price of $500. Since the investor purchased this option for $200, the net profit to the buyer from this trade will be $300, a 150% return.

Also important: Had we shorted 100 shares of the stock outright, it would have cost $10,000 (plus commissions and borrowing costs) to net the same $500.

When the option expires, ABC is trading at $99.
Using the same analysis as shown above, the put option will now be worth $1 (or $100 per contract). Since the investor spent $200 to purchase the contract in the first place, he or she will show a net loss on this trade of $100.

When the option expires, ABC is trading at or above $100.
If ABC ends up at or above $100 on the option’s expiration date, then the contract will expire out of the money. It will now be worthless, so the option buyer will lose 100% of their money (in this case, the full $200 that he or she spent for the option contract).

What’s important to keep in mind here is that losing $200 isn’t the end of the world. Had we shorted the stock outright with 100 shares, we likely would have lost much more. For example, if ABC was at $105 and we shorted 100 shares, we’d be sitting on a $500 loss.

Closing Thoughts

This is where the dangers of shorting — and the benefits of put options — come into play.

With shorting, your losses are theoretically infinite. As long as the stock goes up, you’re losing more and more money. By only paying $200 to control 100 shares with options rather than $10,000 to control 100 shares by shorting ($100 price x 100 shares), we’re risking a lot less capital.

But with put options, you pay for what you want to control. And that’s your only risk of loss. Plus, this keeps plenty of dry powder on hand to pursue other trading ideas.

The bottom line is, if you’ve never considered using put options as a way to protect yourself and profit from an overvalued market, then now is a great time to start.

A Special Invitation For You

If Jim is right about these “zombie” companies, then owning puts on some of these stocks in the coming months could be extremely profitable.

That’s why, for the first time ever, Jim has put together a short presentation that explains what’s going on with these overvalued companies. He also shows investors how he was able to achieve success betting against companies during other periods like this (2008 for example).

He’s already released his first set of trades — with two more in the pipeline, which will be released any day now.

To check out Jim’s brand new presentation and learn how to profit, go here now.