Market News

August 31, 2012  Fri 11:04 AM CT

Sometimes, a stock has been beaten down so much that it seems destined to hit $0. But even if we are eventually right about that direction, it can be very difficult--if not outright dangerous--to attempt to profit from such situations before they go bust.

One of the big issues is the inherent risk short-selling low-priced stocks. Even when stocks seem to be in a death spiral, they still have theoretically unlimited potential upside.

Dendreon is one that comes to mind, as I have watched it pop from single-digit prices on more than one occasion over the years. I remember seeing the pharmaceutical firm trade around $4 with huge short interest while waiting for a regulatory decision on one of its proposed drugs.

You can guess what happened: The ruling was positive, and the shorts got squeezed as the stock jumped above $20. It happened in March 2007 and again in April 2009, when shares eventually ran up to $57 from a low of $2.55.

Of course, one alternative in approaching such names is to use options. Buying puts is a limited-risk way of betting on that $0 price target, but the problem there is the cost. When stocks get very cheap, the volatility is usually very high, making the option premiums a poor choice.

We saw an example of this just this morning in Zynga. With the stock at $3.08, someone was selling the March 2.50 puts for $0.42.

The trader may end up obligated to buy the stock if it trades below the $2.50 strike, but the effective purchase price would be $2.08. If the trader is hoping only to make money on the puts and not get long, however, the stock price would need to be below that level at expiration for the options to profit.

We have seen more extreme examples in stocks that were rumored to be near bankruptcy. The implied volatility of Bear Sterns puts went as high as 700 percent.

But those two cases highlight the big issue with stocks that are struggling in the low single digits: the potential takeover.

Publicly traded companies have value to someone, regardless of how low their stocks go. And bargain-hunting suitors will find such names even more attractive as their share price descends.

So just when a stock seems to have no hope, that may actually be the optimum time for it to reverse higher--perhaps in a very big way, especially if the acquirer offers a generous price.

Mere rumors of a buyout often catch short-sellers off-guard, lifting an otherwise "worthless" stock if only in intraday trading. So from a simple probability standpoint, you are almost always better off selling puts in such cases rather than buying them.

Moreover, if you think that a stock is going to $0, you probably aren't alone. And whenever you share the consensus opinion, it is usually more difficult to make money.

Remember, the best opportunities come when you think that the market is wrong about something and have a thesis based on your research. Otherwise, you're just gambling.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of Aug. 15.)
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