The market is coming unglued before our eyes. Yesterday morning the Dow Jones Industrial Average plunged more than 1,000 points and is down about 15% from its recent highs.

I’m not surprised. I’ve been warning readers for more than a month that a correction — or worse — was around the corner.

#-ad_banner-#My analysis was based on slowing economic data, downward revisions in corporate earnings growth, a strong dollar and the S&P 500’s high price-to-earnings ratio (you can watch my warning here).

I showed readers of my premium newsletter, Profit Amplifier, how to protect themselves from a downturn using a simple options strategy. It’s working. My recent trades have delivered 39% in seven days, 69% in nine days and 33% in just four days.

Given current market conditions, it’s crucial you understand how options work, specifically put options.

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

Puts 101
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 time (the expiration date). Usually you’re 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 stock is currently trading at $100 per share. 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. 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.

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 think owning puts on certain stocks in the coming months will continue to be extremely profitable. That’s because, as I said, the market is in a very precarious place right now.

In my premium options service, Profit Amplifier, we’ve used put options very effectively to magnify our gains from falling securities. Take a look at the track record we’ve been able to achieve so far buying puts in the table below:
 

For the most part, our put trades have been very profitable. In fact, my readers and I have made an average return of 23.5% on our put trades so far, and our average holding period stands at just 28 days — that’s good for a 305% annualized return.

The bottom line is if you’ve never considered using put options as a way to protect yourself and profit from a falling market, then now is a great time to start. I’ve put together a short presentation that explains how options work and more details on how my Profit Amplifier readers and I have been able to achieve our record of success.

If you sign up for my newsletter, I’ll also send you five special reports that will help you get started, including a report called How to Prepare For — and Profit From — the Looming Correction, a Brokerage Guide, an Options 101 course and my special “Black Book” of trading secrets. To learn more, simply visit this link.