Smarter Money: A Puts Primer, Part 1

When someone big sells puts on an index, that index is likely to: a) go down? b) go up? or c) do nothing. If you answered anything but b, this column is for you. Hit the "print" button, take this one home and study it. It will explain something that must be understood if you are going to play or understand these treacherous markets.

Nothing confuses people like puts. Nothing. They are one of these devices that everybody dreads writing about because they are difficult to understand. So let's start very simply. If you want to make a bet against a stock you can short that stock or you can buy a put on it. They are virtually the same thing.

First, let's talk about what puts are not. Let's say you want to bet that National Gift Wrap is going to fall from 50 to 40? You can sell 1,000 shares of National Gift short at 50 and, when it gets to 40, you can buy or "cover" the stock and make 10 points. Ten points times 1,000 shares is $10,000.

Now, let's say you make this same bet, but this time the stock fails to go down. In fact, it rallies 10 points as National Gift has an exceptional holiday season. Now you are out $10,000. You sold the stock at 50, it rallies to 60 and then you buy it. You lose $10,000. Of course, you don't have to buy it, or "cover," but it could always go up even more! ...