How to make money in a falling market: put options

Susan
By Susan April 3, 2012 16:50

How to make money in a falling market: put options

 

 

This is the third post about how to make money in a falling market.

The first one was inspired by Alessio Rastani’s statement that “People were prepared to make money from that crash, and anybody can do that, it isn’t just for the elite.” Anybody? Really? Anybody who is prepared to study finance in depth, that is!

The second post was about one strategy to make money in a falling market: short selling, or shorting the market.

Another strategy is buying put options.

 

Now how about put options?

 

Put options are a kind of insurance.

Let’s say you buy a stock at €100. You are, of course, expecting that stock to go up. But you know that sometimes, well, stocks don’t go up. You knew, when you bought the stock, that nobody made a promise to you that it would go up. You are aware of the danger of it going down, and you accept that risk.

But you have a way to mitigate that risk. You know there is a risk that this stock will go down, but when you factor in everything, you decide that, if you sell it at €80 at the lowest, that’s not too bad. €20 is the kind of risk you can afford to take. So you decide to buy insurance, on the chance that the stock depreciates. Let’s say the insurance costs €5.

Now you know you have mitigated your risk. Whatever happens, the most money you can lose on that stock is €25: the difference between the price at which you bought the stock (€100) and the lower price at which it is trading (€80), plus the price of the insurance (€5). 100-80=20, 20+5=25.

Then your worst fears come true and the stock plunges to €40. If you hadn’t taken insurance, you would have lost €60. But, even though the stock is now selling for €40, you can still sell it for €80, thanks to the insurance. Now you’re glad you took the precaution!

 

As the stock falls, the insurance contract rises in value

 

However, let’s think about this. Now that the stock has plunged in value, hasn’t the insurance contract suddenly become much more valuable? The person who was mitigating a potential loss of €20 has now in a very real way, saved themselves a €40 loss. This may not sound like a lot of money, but multiply it by a million and see what you think then! In fact, the €5 insurance policy could now be worth €50!

As a result, if you did have a view that a stock or market was about to fall, you could buy this insurance with a view to selling it later on (if, and) when the insurance contract rises in value. The insurance applies to a certain stock, but you don’t have to own that stock to be able to buy the corresponding insurance.

So one way to make money in a downward market is to buy insurance and then to sell the insurance to hapless owners of depreciated stocks. Once again, you will need to be watching that market like a hawk, because these contracts are highly volatile.

 

Are you prepared for this level of volatility?

 

The volatility of the insurance contract is far higher than that of the stock: the put price can change much faster than the stock price. You have to be able to handle that and understand what is likely to happen, and whether there is a change in the underlying stock. This means being very clear on your scenario analysis.

Put options, being insurance contracts, work in a way that is similar to your car insurance. If you don’t damage your car, the insurance company simply keeps the premium. You have in effect “lost” the money. But few of us think of car insurance as wasted money, do we? And for very good reason.

So, that was my opinion of “Anybody can make money in a downward economy”. Anybody can do it, if they put a lot of time into understanding it. I taught myself how to do it, but I didn’t just jump in. Training can expedite the process no end, but you can’t cut through the understanding.

It takes time and shortcuts aren’t rewarded!

That is it, end of rant. And next time a so-called expert and self-confessed attention seeker is interviewed, I hope you won’t fall for it!

If you found this article useful, you might want to subscribe to the blog, to get new posts as soon as they are published.

 

You can also read this very interesting interview, where Mr Rastani seems to be muddling his way through while he thinks of something to say, is buying time left, right and center and skillfully manages to end the interview without having given even one relevant answer to any of the questions.

You will see that the journalist asks him “What do you think of VIX?” For your information, when I am asked that question, I go on and discuss what VIX is and what I think of it. I don’t try to buy time by spelling it out first.

 

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Susan
By Susan April 3, 2012 16:50