Earlier this year, I made the case to readers of my premium options service, Profit Amplifier, that a market correction could happen sometime this year. Just a few months later, that time has come.

I recently warned investors about trouble brewing in Russia and China, and I was on the front lines during the dot-com bubble and its subsequent burst. Fortunately, I accurately foresaw both the dot-com bust and the 2008 financial collapse as well. And I not only survived both events, but prospered.

#-ad_banner-#This time around, often-overlooked warning signs suggest hundreds of popular investments will be in danger of experiencing 10% to 30% drops. And at worst, we could see a full-blown, longer-term correction.

But once again, my readers and I have the chance to not only protect ourselves, but even profit handsomely from the trouble that’s on the horizon. And we’ll do it in a very simple, easy-to-understand way — by using put options.

Given current market risk, it’s crucial you understand how options work. In early June, I introduced you to the basics of call options. Today, I’d like to discuss put options, which will be an especially important tool when a market downturn occurs.

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 101: How To Use Options To Profit From Declines
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, I teach traders to focus on in-the-money options, as they will closely mimic the stock.

Example: Put Options Contract
Let’s say IBM (NYSE: IBM) shares are currently trading at $100. An investor then purchases one put option contract on IBM with a $100 strike price at a premium of $2.

The premium is the price you’re paying for the right to sell 100 IBM 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, IBM is trading at $95.
The put option gives the buyer the right to sell shares of IBM 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, IBM 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, IBM is trading at or above $100.
If IBM 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 his or her 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 IBM was at $105 and we shorted 100 shares, we’d be sitting on a $500 loss.

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 only risk losing what you pay to control. Plus, you have plenty of dry powder left to pursue other trading ideas.

I believe owning puts on certain stocks in the coming months could be extremely profitable. That’s because, as I said, the market is due for a correction. But even if I’m wrong, there are still plenty of opportunities to profit from overvalued stocks in this market.

In my premium options service, Profit Amplifier, we use both calls and puts to magnify our gains. So far, by sticking to our strategy, we’ve won more than we’ve lost.

Take a look at the track record we’ve been able to achieve by using put options to take advantage of small pullbacks in stocks:
 

For the most part, our path to success has been very profitable. In fact, my readers and I have posted an average return of 27.9% on our closed put trades so far, and our average holding period stands at just 30 days — that’s good for a 340% annualized return.

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. I’ve put together a short presentation that explains how options work and how my Profit Amplifier readers have been able to achieve success.

This article was originally published on ProfitableTrading.com:​ A Simple Way to Short Stocks With Less Risk