So, the U.S. government has decided to inject itself into the financial situation and you cannot short sell financial stock. What is a trader to do? One option is to buy some puts ... but before delving into the strategy, let's recap what has happened thus far (for a more detailed rundown, check out Elizabeth Harrow's coverage from earlier today):

• The Securities and Exchange Commission (SEC) declared it illegal to sell financial firms short, issuing an emergency order to halt such activity through October 2.


• The U.S. Treasury announced that it will insure any publicly offered money-market fund; retail or institutional.


• The Federal Reserve announced that it plans to buy short-term debt issued by Fannie Mae (FNM) and Freddie Mac (FRE) from primary dealers. The New York Fed stated that it will hold a series of "competitive auctions" with primary dealers to purchase the securities.

Confused? Wondering what this means to the everyday trader? You aren't alone. We have received a number of questions about the regulations, what they mean, and if there is an options-trading strategy that could help.

Guess what, there is a strategy - buying puts.

Buying Puts

Put buying is the most basic options trading strategy at your disposal when you expect a stock's value to drop. By purchasing a put, you are investing in the belief that a particular security's value will fall below a certain price by the option's expiration date.

Here are a couple of things to keep in mind when buying puts:

• Puts can allow you to profit from a downward move in an equity.


• Since you are buying an option, you have the right, though not the obligation, to sell the underlying shares at the strike price. Thus, you do not have to own the shares to buy a put. Only if you exercise your put option would you have to go out in the open market, buy the shares, and then sell the stock at the contract (strike) price. Bear in mind that you will incur 2 stock commissions - 1 to buy the shares and 1 to sell them to the put seller.


• The simplest alternative to capture a profit is to sell the put for a gain after a decline in the stock.

If you exercise a put, you end up either with a short stock position (which is currently prohibited on certain financial issues)or no stock position. A short stock position results if you sell the stock at the put strike but don't own the shares. You end up with no stock position if:

1. you already owned the shares (in other words, the put you bought was for protection, also known as a "married put") and you sell them at the strike price, or
   
2. you didn't own the shares (in other words, you bought the put for speculation) and you decide to go out and buy the shares and then sell them at the strike.

Some investors might tend to shy away from puts, preferring instead to short the stock. Put buying is a limited-risk alternative to short selling, as they provide leverage without the added cost of margin. Purchasing puts also frees the trader from paying dividends, which is required of the short seller.

A Put-Buying Scenario

Let's look at a hypothetical put-buying scenario. You feel very bearish about XYZ Inc. Your indicators may result from market analysis or simply a gut feeling, but either way, you are certain that XYZ, which is currently trading at 50, will decline below 45 within 2 months. Your course of action is to either short the stock at 50, or buy an XYZ 50 put that expires in 2 months at a cost of 5.

The following table shows the profit and loss of these 2 strategies at various stock prices at expiration. Note that the short position is more profitable by the amount of the put's premium (5 points) as long as the stock stays flat or moves lower. Above 50, the put position has reached its maximum loss point at 5, while the short position continues losing at a linear rate. At 55, both positions are saddled with a loss of 5, while above 55, the short sale incurs a larger loss than the put purchase.