A year ago, I explained how I made a 500% trading profit in less than a month. To summarize, I bought a put option on 3M Company (NYSE: MMM) shortly before the stock took a dive. A put option increases in value when the price of the underlying security goes down.

At that time, 3M was hoping that it could avoid culpability for defective earplugs one of its subsidiaries sold to the military. However, a federal judge ruled against them. Wall Street analysts estimated the total potential liability to 3M in a range of $4 billion to $10 billion.

After closing out that trade for a huge gain, I pretty much forgot about 3M. I figured its share price would not gain any ground until it put its legal troubles behind it.

I was right about that. Since then, 3M has bounced back and forth but is lower now than it was then. Two years ago, before the onset of its current legal problems, 3M was trading above $200. Now, it’s struggling to get back above $110.

Two weeks ago, Bloomberg reported that 3M’s preliminary master class-action settlement of most of the defective earplugs lawsuits might be jeopardy. For that deal to go through, at least 98% of the claimants must agree to it or 3M can withdraw the offer.

That deal would pay each claimant approximately $24,000. Multiply that by 250,000 claimants and it comes out to about $6 billion.

I’ll admit, $6 billion is a lot of money to 3M. However, I don’t believe $24,000 is a lot of money to someone who has suffered hearing loss due to a defective product.

Coming Up Short

As that article points out, “3M lost 10 of 16 early cases tried, and the juries awarded the plaintiffs a total of $265 million in damages.” That works out to an average payout of $26.5 million per winning claimant.

From the claimants’ perspective, $26.5 million sounds a lot better than $24,000. About 1,100 times better, to be precise. For that reason, I don’t think 98% of the active claimants will agree to the proposed settlement.

If that turns out to be the case, 3M could be in for a world of hurt. Potentially, the company may have to declare bankruptcy to remain liquid.

For that reason, I’m surprised short interest in 3M is only 2%. Short interest is the number of shares sold short divided into the total number of shares outstanding.

WATCH THIS VIDEO: The “FUD” Factor: Overcoming Fear, Uncertainty and Doubt

A year ago, short interest in 3M spiked above 10% shortly after the judge’s decision to hold the company liable. However, those shorts were covered a few weeks later after 3M’s share price tanked for a tidy profit.

I think something similar is about to happen. The downside risk to short sellers is modest since 3M is currently valued at relatively high multiples to sales and earnings. Even if it settles the lawsuits, Wall Street won’t be excited by its shrinking revenue stream.

However, the upside potential to a short sale is enormous. If 3M declares bankruptcy, its share price could drop in half in a matter of days.

That’s why I expect to see short interest in 3M climb steadily in the weeks to come. That would put downward pressure on its share price, further exacerbating its financial difficulties.

I hope that doesn’t happen, since that would result in a lot of layoffs. But at the same time, I cannot ignore what appears to be a train wreck in the making.

Headed for Trouble

Most individual investors do not engage in short selling. It’s risky, it’s cumbersome, and if you’re wrong about the direction of the share price then it can get very expensive in a hurry.

That’s why I prefer to use put options when I think a company is headed for trouble. It’s easy to do and the financial risk is limited to the cost of the option.

For example, last week while 3M was trading near $107, the put option that expires on December 15 at the $100 strike price could be bought for $2.50 per share.

That means 3M would have to fall below $97.50 for that trade to be profitable at expiration. That’s requires a share price decline of 9% in three months. It traded below that price as recently as two months ago, so it could just as easily go back there in the same amount of time.

I’ll be the first to admit, that type of speculative trading is risky. I’m okay with it because I do this for a living. But for most investors, a more reliable trading system is preferable.

If you’re looking for ways to generate steady income, regardless of the market’s ups and downs, consider my colleague Robert Rapier.

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