I often hear people get rich when market is up, but people get even richer when market is down. How can that be done? I often wonder to myself. As a ”half-cooked” stock investor myself, buy stock at the reasonable price and sell when it appreciate only make sense, but that will only earn me money during a bull market (market up), there is no way to make money with that method when market goes down and the only reasonable move is to wait it out.
That doesn’t apply to professional investor who knows different stock investing instruments other than buying a cheap stock. There are two different methods (but not limited to) professional investor use to make money despite market direction, these are; short selling, and options trading. While options trading consists of buying and selling options.
Short Selling – Selling stock that you don’t own and hope to buy back the stock at a lower price. Let say you think a stock will go down in price from $20 and you target the price to drop till $10. You call your stock broker and tell him you want to sell 1000 unit of stock you don’t own at $20. $20,000 will be deposited to your account. Let say the stock really go down to $10 and you buy back the 1000 units of the stock at $10,000. In this short position, you earn a maximum $10,000 excluding brokerage fee and processing fee. If you ever wonder how people make lots of money out of thin air, this is one way.
However the cons is, short seller is usually given a limited time to buy back the stock that you have sold. In other event if the price go the other way, says $25 with total value amounting to $25,000, you need to fork out another $5,000. ($25,000 – $20,000) and returning the $20,000 you borrowed previously.
High Risk Alert: In short position, one have to monitor closely the share price in case it goes sky high! and sky high means there is no limit to the risk. You should know what you are doing.
Buying Put Options – Buying option is like buying insurance for the stock you have already own because you’re afraid it might go down. Let say you own a stock for a long time which appreciated from $10 to $20. Now the stock price doesn’t seem to go any higher and most probably it will go down for a correction, yet you don’t want to sell it because it will probably go up, who knows, no people can fully understand the market. So you buy a put option at $20 for a price on number of shares you own. If the stock price really go down to $15 after that, you now have the OPTION to sell at $20 to lock in your profit.
Buying Call Options – Let say the stock you sold at $15 eventually went down to $10. Now you think it probably will go up very soon, but you just don’t want to make any move yet. So you buy a call option with a price for that stock at $10 for the number of shares you want to buy in the future. If the stock price eventually go up to $15, and $20, then you have the OPTION to buy the stock at $10.
However the cons is; options too, will expire. In the buy call option example above, if the stock go up only after your option expired then you don’t have the option to buy at $10 anymore.
When there are people buying insurance there are people selling insurance. Similarly, when there are people buying options there are people selling option. Professional investors make even more money by selling options, knowing the odds, just like insurance business.
Risk Alert: Risk is limited to number of share options you are committed to, the worst case scenario is the unexercised option goes expired and become worthless. Some broker do provide standing order for option exercising (you need to check), but that only mean you will automatically sell or buy underlying share on options expiry – in the event if your call options go expired and you will automatically buy the underlying shares which require additional cash from you – so BEWARE.
Selling Put Options - When selling put options, you are providing option for the option buyer to sell the share at a pre-determined price. For example: After some market turbulance, the stock price is plummeted to $10 from $20 peaked. Because the stock holders are in panic, so it might be good idea for you to sell put options for the stock at $10 (as price guarantee to options buyer). Of course as option seller you think otherwise, you sell put option only when you are almost sure the stock price will stagnant or go up. In this case if the price really go down, you will have to pay the stock at $10.
Selling Call Options – When selling call options, you are providing option for the option buyer to buy the share at a pre-determined price. As call option seller you sell this option only when you think the stock is going stagnant or down. If the price do go up, you will have to sell the stock at the pre-determined price when actually the price is already a few times higher.
High Risk Alert: There is no risk limit to selling options. Since the price can go down and up forever in put and call option. So make sure you know what you are doing.
Difference of selling and buying options is that, you get cash advance in term of “premium” when you sell the put/call option, while in buying options, you have option of selling or buying at a pre-determined price.
To help you understand more in option, one of the example in real life is when buying house. In real estate term, we call it down payment. Putting a down payment is like buying a call option, you exercise the option to buy the house at the pre-determined price (between you and seller) even though the house price appreciates after some time.
To understand more about option, check out Options made Easy
