There is profit to be made in a falling market

(Last Updated On: 10/09/2019)
You don’t get to see this often. The date is 4 August 2011.

 

The Street slumped 3 percent, and it is not even mid day, yet

 

See Yahoo Finance breaking news remark below. 
Are you emotionally ready for such day? Do you…

a) cower in fear and pray that the market will somehow rebound the next day (or perhaps, never?).
b) execute panic-selling to prevent further sleepless nights.
c) spit it all out at your local mamak stall, be the know-it-all on the economy and what will happen in the next few months, but your money is still in Fixed Deposits, earning a measly interest of 3 percent per year.
d) take some calculative risk and be the contrarian.

If you tell put the phrases “making profit” and “falling market” in the same sentence few years ago, I wouldn’t be able to comprehend.

I do, now. Having said that, it is not without its risk. Quite high risks actually. Not for the faint-hearted, but that’s another post for another day.

The first is by short-selling.

The concept is simple. You sell stocks which you do not own, or which is “borrowed” from your brokerage. You receive the money from the sale. Next, if the stock price goes down, you buy back the stocks at a lower price to “return” the stocks to your brokerage. The difference in price is your profit.

Put in another way, it is just a reverse of conventional, “buy first, then sell later at profit” concept. In commodity sense, this is not possible because you cannot sell something without first buying it first. Stock is a different scenario.

Second, and perhaps a “cheaper” way to do this, is by buying put options, a form of investment securities known as derivatives. An put option is a contract that gives the option buyer the right, but not the obligation, to buy the stock at a predetermined strike price on or before a certain date. But it gets more complicated than this because the contract also has its intrinsic value. This intrinsic value is just a fraction of the stock price, and it varies depending on how far or near the current stock price is to this strike price. Therefore, the price you pay for the one put option contract of 100 shares is much lower than the equivalent number of the actual shares for the same company. This intrinsic value tracks the stock price. In the case of put option, its intrinsic value increases as the stock price approaches or goes below the specific price. You profit by selling the put option as its intrinsic value increases beyond your purchase cost.
Imagine if you bought a $32.50 put option on 1st June 2011, at, say, $ 150 per contract, which expires in Sept 2011. Closing price at 31st May is $42.85

On 17 June, after RIMM’s quarterly earnings, the stock price dropped from $35.xx to $27.xx in one day.

Now, while stock price is  $23.59, your one option contract will be worth $ 890 as of 4 August 2011 after market close pricing. You sell your contract.
Click to get enlarged view
Unfortunately, both are not applicable in Malaysia. There are no options trading in Malaysia share market, and short selling is illegal.

This Post Has 5 Comments

  1. Hi Boon Eng, you are correct, if you are seeing option from the perspective of owning the rights, not the obligation, to buy or sell the shares.
    However, regardless of call or put options contract, the contract itself has its intrinsic value. When any option is at/in the money, the option become more valuable than the time you bought it previously. Hence, instead of exercising your rights, you sell the option, and the profit is the difference between the cost of your option purchase price and the selling price.

  2. hmmm…slightly confused.If i understood correctly, put option should be right to “sell” and not right to “buy”, isn't it?

  3. Michael, you can always trade options and short selling in the Land of Dreams (or it used to be) aka U.S.A instead of waiting for our politicians to approve the “illegal” activities in Bolehland..haha 😛

  4. ” There are no options trading in Malaysia share market, and short selling is illegal.”

    thats why ppl here are crazy about forex …

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