Chapter 6
There already are financial "tools" in place for this, namely, shorting the stock, buying put options, or selling call options. Let's look at each of these. Before we do that, why would anybody want to be involved with a falling stock...perhaps to make more money? A simple investor would hold their shares and buy more of them as it goes down. However, this is an old idea that doesn't work as well as just getting out of the stock until it's found a bottom and has started heading back up.
Shorting the Stock
In normal circumstances, we can't sell something we don't own. However, the brokerage firm has the facilities to do that and it has been possible for 100 years. This is sometimes called "shorting" or selling short. It means you are short (don't have) the stock. The broker has it in inventory from another customer. You sell the shares via the broker, and you have an IOU for those shares. There are rules of course around shorting. It can only be done on an up tick of the price (just during the beginning of the short - rules from 1930's), and you need to have sufficient money at hand to cover a movement in the stock price if it goes against you. If the stock is going up, then you are losing money and if it goes too far, the broker will buy it back to cover (close out) the position and use your cash in the account to cover the difference.
It the stock goes down as expected, then you buy it back and your IOU for the shares is removed. The "sell high" was done first, and the "buy low" was done second. Same principle...but it is a different order than the usual "buy low, sell high." The risk is the same with stocks. Every cent is one-to-one and you probably need to have alot of money to hold that position relative to the movement. This is normal stock profits, but can be higher returns since stocks usually drop faster than they rise. Higher speed is better wealth velocity.
Buying Put Options
Stock options are contracts to buy or sell shares, if they are exercised at an expiry date. We don't need to exercise the option but we have the right to do so. The option (contract) is for a specific price and consists of 100 shares. There are two types of options: calls and puts. A put lets you sell your shares to another person for a pre-set known price. For example, if we bought a 80 Put on MSFT, we have the contractual right to sell 100 share of Microsoft at $80 per share. We get paid, and they get the shares. Its a prearranged sale. The seller of the put is obliged to give use the money and take the shares at that price.
Prior to the option expiry date we can sell the value of that option to someone else. Or we can wait until expiry and sell the shares to the person that created (sold) the put option...it's our choice. Either way, if the share price went down we would be making a profit.
Selling Call Options
The seller of a call option has the obligation to deliver the shares to the buyer of the option. Its a set contract for a specific price and date. If a stock goes up above the "strike price" then we would need to deliver the shares of the stock on the expiry date of the contract. If the stock doesn't reach the agreed strike price, then the contract (option) expires worthless. The call option has value prior to expiry. As the seller of the option, we get paid that options value. The goal of making money from a falling stock is to get paid for the value of the option and hopefully there is no need to deliver the shares (which would be worth more than we expected) at the agreed price. The option loses value after the sale when the stock price falls. If the stock price rises we have the risk of paying an unknown (increasing) price. In addition, we have the right to buy back the call option and close our position at any time before the expiry date.
Each of these methods above have a risk versus reward ratio. For inexperienced investors, they are not recommended. If you have experience, you can learn more about the potential risk. There are some interesting tools to help you decide if a stock is being "sold short" heavily. The "short interest" is available in the Wall Street Genius software. Also, there are lists that show which stocks have large short interest (heavily sold short already). It can assist in making good decisions to ride with the bearish herd and also see when the sellers are getting out and need to buy back their shares. When short sellers get out, they need to buy the shares and that can cause the stock to rise. It might be time to buy at the bottom if the stock is worthy of being bought.
