One of the first rules of investing that you should realize is this: corrections happen often. It’s just part of the deal.
If you are like most investors, you probably have a core set of investments that you will never sell no matter what happens, either because you are looking to keep the dividends flowing from those investments or because you are a subscriber to Harry Markowitz’ Market Portfolio Theory, and then you have a couple of stocks that you are willing to sell.
In the case of stocks that you are willing to part with, how can you protect yourself from market drops with these investments? There are basically three ways, and you can actually make money by executing these options correctly:
Option 1: Short the Stock
Alright, so let’s say that you think an investment is about to drop. Your first, and most basic, option is to “short” the stock.
Opposite of “longing” a stock, where you buy and hope that the price of the stock rises, shorting is where you agree to “buy to sell” the stock from a broker at the current price at a later date.
If the stock goes down, you make money since you can now buy it more cheaply than you can sell it.
However, if the stock goes up then you are still required to buy and sell the stock, thereby losing money on the difference between the new stock price and the old stock price.
Furthermore, you will be required to have margin (credit) on your account since shorting is viewed by most brokers as being very risky.
Option 2: Sell Call Options
A call option gives a buyer of that option the right to buy a stock at a predetermined “strike price” at a later date. If the stock goes down beneath that strike price, the call expires worthless.
So, if you believe that a stock is about to go down, you can sell calls (known as “writing calls”) and pocket the option premiums given to you by the buyers if you are correct.
Option 3: Purchase Put Options
Converse to a call option, a put option gives a buyer the right to sell a stock at a predetermined strike price in the future.
Therefore, a buyer of a put option hopes that the stock price falls beneath the strike price because then that option holder can sell the stock at a price that is greater than the current market value.
So, if you believe that the stock market is going to go down, then you could buy a put in the hopes of capitalizing on the move.
What’s the Best Option?
With all of these options at your disposal, which one is the best to use? Well, that all depends on your situation. Shorting a stock and selling calls have inherently high risk, since your risk is technically infinity if the stock price goes up indefinitely.
However, the put option will require you to pay a premium that you are at risk of losing if the stock doesn’t move enough by the expiration date. You can also take online trading classes to help learn more about the industry.
So, if you are seriously concerned about a stock market drop, then you need to know that you have options.
However, you also need to understand that all of these options carry greater risk than that which is found in simply buying stock. As a result, you should always consult your personal financial advisor before making any big moves.