Shorting A Stock
The first strategy is shorting a stock. So what does this mean and how does it work?
Well, it means that you can sell a stock right now even if you don’t own it, and then buy it back later at a cheaper price.
Here’s how it works. So first there is your broker, then there’s you who wants to participate and make money in a falling market.
Let’s use Apple (AAPL) as an example.
Let us pretend AAPL is currently trading at $119 & we believe that Apple actually might go down again to $110.
You can make money betting against Apple in a falling market, and here’s how.
Now, you want to sell Apple, but you don’t have the shares just yet. So what you would do is you borrow shares from your broker.
So your broker is actually lending you 100 shares of Apple (at least for this example it’s 100 shares).
Now, the price at this point doesn’t matter. He’s just giving you the shares and says,
“OK, you need to give me back these shares later on.”
And he is actually reserving some money from your trading account to make sure that you really give it back to him.
Now you have 100 shares, and you can do with these 100 shares pretty much whatever you want.
So in this example, you would sell them to Trader 1. So you sell Apple, 100 shares of them, at the current price of $119 because you believe that Apple will go down.
So how exactly do you make money? Well, this is where we bring in Trader 2.
Let’s say after a few days AAPL does in fact drop down to $110.
Here’s what happens next. Now you are buying back AAPL at $110.
So how much money do you make? If you sold Apple for $119 and you’re now buying it back AT $110, you’re making $9 per share, multiplied by 100 shares. This comes to $900 in profit.
Now that you have the shares back, you, of course, have to give them back to the broker.
Remember, the broker lent you the shares, so you have to give them back those 100 shares of AAPL. And when you do, the broker releases the money that they held, kind of in escrow, to make sure that you are getting the money back.
The beautiful thing is this is all going on in the background.
Now I want to show you how this looks on a trading platform.
So now I want to trade Apple, and I want to sell 100 shares. All I need to do here is, you see it says already short minus 100, and I would sell them at the current price of $119.35. So I click review and send.
And you see that right now the broker is requesting almost $6,000 from me. And the $6,000 is basically the money that he’s holding in escrow to say,
“All right, Markus, you have to give me back the shares.”
It’s that easy.
And now if I click on “Send Order,” I would sell the shares.
So this is the first way, because I told you that I’ll give you two strategies of how to benefit from a falling market. So this was strategy number one, shorting a stock.
Buying A Put Option
Now, let’s move on to strategy number two. You would buy a put option.
“Put” means that you have the right to sell a stock at the strike price.
Again, we will be using the same example of AAPL that we used for the first strategy.
So as I just said, we’re pretending AAPL right now is trading at around $119 and we believe that Apple will go down to $110.
This is how this would work.
This is where we are looking at an Apple put, let’s say here, Apple put of 119, and you can see it is trading at around $1.80.
So here is what exactly we would do.
We would buy a put for $1.80. This put gives us the right to sell Apple for $119.
Now, if Apple really goes all the way down to $100, same deal here, we would make $9 per stock. However, we have to deduct the premium that we paid for the option, which is $1.80.
So this means here we are making $7.20 per share ($9 – $1.80).
If we would trade one option, one option controls 100 shares, so this means that we are making $720 total.
Which Strategy Should You Use?
The main difference between these two strategies is that, for strategy number two buying a put, you don’t need as much money.
Remember earlier I wanted to sell Apple 100 shares, and my broker was reserving around $6,000 dollars in my account?
Now, take a look at this.
If I want to buy this option, it would only cost me $180. So as you can see, huge difference.
In the one case, the broker is reserving $6,000 with the possibility of making $900.
For strategy two, buying a put, your broker is only requesting $180 and that is also the maximum amount that you can lose, and you can make possibly $720 here.
So this is how you can make money in a falling market.
Now, very important. Strategy number one, where you’re just shorting the stock and where the broker is lending you the stock, you cannot do that in a retirement account.
But strategy number two, buying a put, you CAN do in a retirement account, and you can do this for any stock.
Now, you might actually be bullish on Apple, but if you look at some other stocks right now that were in a downtrend, for example, Zoom, if you say,
“Oh my gosh, Zoom is crazy, during the pandemic here,”
It went from, what? $50 to $500? You could think,
“This is absolutely overvalued and I believe that Zoom will go down to $300”
Then you can use one of these strategies.
So if you see all of these stocks that, during the pandemic benefited a lot and could actually move lower, this is how you can make money in a falling market.
Now you know two strategies how to make money in a falling market and how to bet on a stock that is going down.
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