When it comes to the stock market, you might have heard extreme scenarios such as making fortune by trading stocks or losing it all. Both of them are true because trading is a zero-sum game (meaning someone’s loss is someone else’s profit). Many people think that one can only buy and sell stocks but in reality, you can do much more than just buy/sell. In this post, I will scratch the surface of different things one can do with stocks.
Stocks are just like any other commodity like a car. You can buy a car, sell it, rent it, lend it, insure it. You can do the same with stocks.
Just like how a dealership makes money when you buy/sell; your broker makes money when you buy/sell a stock. Even if your broker advertises that they will charge 0$ commission to you; they will always make money on each trade that happens through them. That is a whole different story.
To make a profit in any commodity, you need to buy it at a lower price and sell it at a higher price. In the case of stock, you can switch the order. You sell it at a higher price first and buy it at a lower price. You may wonder how can I sell something that I don’t even own. The answer is you borrow it. So, the sequence will look like the following:
- you borrow a stock from someone else
- sell it
- when the price goes down, you buy a stock
- return it to the borrower
This is known as “short selling”. When you borrow a car, you pay some money to the borrower; you do the same when you borrow a stock. Borrow/lend operations are handled by your stockbroker. When demand for borrowing is high, your broker might borrow a stock that you own lend it to someone else and give you some percentage just because you own the stock. Isn’t it cool?
So far we have covered, borrow & lend operation.
In the real world, we buy a car-insurance by paying some money. If something bad happens then you claim the insurance. Insurance has an expiry date. You need to renew your insurance every couple of months. In the same token, for a stock, you can buy an insurance (a.k.a. option) & renew it. If the price of a stock drops drastically, you can execute your option.
An option is a separate discussion in itself. To make this simple to understand, Assume that you bought a stock at $10. This stock is extremely volatile meaning that it can turn to $5 or $15 within a short timespan.
A stock is usually volatile when supply & demand are not in balance. We have seen the same with hand-sanitizers during the pandemic. When supply was meeting the demand, prices were low but when demand exceeded supply the prices went high. You can say that during the pandemic, the hand-sanitizers price was highly volatile.
To protect your $10 stock, you bought an option for $1. $1 is known as premium. Just like normal insurance, a stock option has condition & expiry date. Our $1 option expires in a week & condition is that if the stock price goes down then the insurance company will pay you $8 for your stock.
If you want an insurance company to pay $9 for your stock; you would have to pay a higher premium (maybe $2 in this case). For $10, you would have to pay an even higher premium (maybe $3).
- Suddenly, your stock is in demand. The current price of your stock is $15 then you don’t claim your insurance (a.k.a. exercise option). Your net profit would be 15 (selling price)-10 (buying price)-1 (premium)=$4.
- If stock price lowered to $5 within a week, you can claim your insurance (a.k.a. exercise your option). You sell your stock to the insurance company for $8. Without insurance, you could have lost $5. With insurance, you lost only $3 [$10 (buying price)+$1(premium)-$8(selling price)].
- If a stock price remained the same. Then you don’t claim your insurance (a.k.a. exercise your option)
In the case of stock, anyone can sell an option. It can be an individual or a company. Some people make living out of options trading.
Stocks are awesome than cars because if you keep a car it would not pay you any money. But, if you hold certain kinds of stocks, you might even receive some money (a.k.a. dividend) just to hold it.
In this post, I have tried to oversimplified some complex terms. I hope that you enjoyed it.