Investing and trading are the two ways to make money in the stock market. But if you are an investor, you will only make money when the market is trending upwards. What when the markets are falling? How will you generate returns when the market goes into a downtrend?
Many traders and investors are unaware of the alternative way of generating income in falling markets, as they tend to stay away from the market during such times. Before understanding how to generate returns in a falling market, let us know about the three phases of markets:
Bullish Market: A market trending upwards due to the rise in prices of the shares is called a bullish market.
Sideways Market: The term sideways market means there are no clear trends found in the market.
Bearish Market: A market trending downwards due to the fall in shares prices is called a bearish market.
Financial markets around the globe include asset classes such as equities, derivatives, currencies, and commodities for trading. Equities are nothing but stocks that are traded in the Equity-Cash market.
Dr. Kamakhya Narain Singh, IEPF Chair Professor at IICA said, “Trading in futures and options market is high risk and high reward activity.”
A derivative is an instrument whose value is derived from its underlying assets like stocks, currencies, and commodities. The three most common types of derivative instruments are Forwards, Futures and Options.
American investment manager James Chanos, said, “Derivatives in and of themselves are not evil. There’s nothing evil about how they are traded, how they are accounted for, and how they are financed, like any other financial instrument, if done properly.”
A forward market is a marketplace that sets the price of assets and financial instruments for future delivery and is used for trading. It allows contract parties to customize the time, amount, and rate at which the contract will be performed.
For example, consider the case of a farmer who harvests a particular crop but is uncertain about its pricing three months later. In this situation, the farmer can lock in the price at which he will sell his produce in the next three months, by entering into a forward contract with a third party.
In an interview with Forbes magazine, Berkshire Hathway CEO Warren Buffet said, “The future is never clear”, citing the uncertainty of the market.
A futures market is a central financial exchange where participants buy and sell futures contracts for delivery on a specified date.
Futures are exchange-traded derivative contracts that lock in the future delivery of a commodity or security at a price set today.
Futures contracts are made in an attempt by producers and suppliers of commodities to avoid market volatility. These producers and suppliers negotiate contracts with an investor who agrees to take on both the risk and reward of a volatile market.
Futures markets are where these financial products are bought and sold for delivery at some agreed-upon date in the future with a price fixed at the time of the deal. Futures markets are for more than simple agricultural contracts, and now involve the buying, selling, and hedging of financial products and future values of interest rates.
Futures contracts can be made or “created” as long as open interest is increased, unlike other securities that are issued.
Imagine an oil producer who plans to produce one million barrels of oil over the next year. It will be ready for delivery in 12 months. Assume the current price is $75 per barrel. The producer could produce the oil, and then sell it at the current market prices one year from today.
Given the volatility of oil prices, the market price at that time could be very different from the current price. If the oil producer thinks oil will be higher in one year, they may opt not to lock in the price now. But, if they think $75 is a good price, they could lock in a guaranteed sale price by entering into a futures contract.
By entering into this contract, in one year the producer is obligated to deliver one million barrels of oil and is guaranteed to receive $75 million. The $75 price per barrel is received regardless of where spot market prices are at the time.
Standardized contracts
For example, one oil contract on the Chicago Mercantile Exchange (CME) is for 1,000 barrels of oil. Therefore, if someone wanted to lock in a price (selling or buying) on 100,000 barrels of oil, they would need to buy/sell 100 contracts. To lock in a price on one million barrels of oil/they would need to buy/sell 1,000 contracts.
Retail traders and portfolio managers are not interested in delivering or receiving the underlying asset. A retail trader has little need to receive 1,000 barrels of oil, but they may be interested in capturing a profit on the price moves of oil.
Futures contracts can be traded purely for profit, as long as the trade is closed before expiration. Many futures contracts expire on the third Friday of the month, but contracts do vary so check the specifications of contracts before trading them.
For example, it is January, and April contracts are trading at $55. If a trader believes that the price of oil will rise before the contract expires in April, they could buy the contract at $55. This gives them control of 1,000 barrels of oil. They are not required to pay $55,000 ($55 x 1,000 barrels) for this privilege, though. Rather, the broker only requires an initial margin payment, typically of a few thousand dollars for each contract.
The profit or loss of the position fluctuates in the account as the price of the futures contract moves. If the loss gets too big, the broker will ask the trader to deposit more money to cover the loss. This is called maintenance margin.
The final profit or loss of the trade is realized when the trade is closed. In this case, if the buyer sells the contract at $60, they make $5,000 [($60-$55) x 1,000]. Alternatively, if the price drops to $50 and they close out the position there, they lose $5,000.
The advantage is that you can also sell first and buy later in the futures market. This process is known as Shorting Futures.
Examples of futures markets are the New York Mercantile Exchange (NYMEX), the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBoT), etc.
CA Rachana Ranade, a Chartered Accountant, on Twitter wrote, “If you trade in futures and options without proper knowledge, you will have no future, and you will be left with no options.”
The term option refers to a financial instrument that is based on the value of underlying securities such as stocks.
Options are versatile financial products. These contracts involve a buyer and seller, where the buyer pays a premium for the rights granted by the contract.
Traders and investors buy and sell options for several reasons. Options allow a trader to hold a position in an asset at a lower cost than buying them. Investors use options to reduce the risk exposure of their portfolios.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
Ways to participate in options market
Buying Call Options
Call options allow the holder to buy an underlying security at the stated price called the strike price, by the expiration date called the expiry. The holder has no obligation to buy the asset if they do not want to purchase the asset. The risk to the buyer is limited to the premium paid. Fluctuations of the underlying stock have no impact.
Buyers are bullish on a stock and believe the share price will rise above the strike price before the option expires.
Their profit on this trade is the market share price less the strike share price plus the expense of the option — the premium paid and any brokerage commission to place the orders. The result is multiplied by the number of option contracts purchased, then multiplied by 100 — assuming each contract represents 100 shares.
If the underlying stock price does not move above the strike price by the expiration date, the option expires worthlessly. The holder is not required to buy the shares but will lose the premium paid for the call.
For example, suppose Microsoft (MFST) shares trade at $100 per share and you believe they will increase in value. You decide to buy a call option to benefit from an increase in the stock’s price.
You purchase one call option with a strike price of $115 for one month in the future for 37 cents per share, called your premium. Your total cash outlay is $37 for the position plus fees and commissions (0.37 x 100 = $37).
If the stock rises to $116, your option will be worth $1. The profit on the option position would be 170.3% since you paid 37 cents and earned $1—that’s much higher than the 16% increase in the underlying stock price from $100 to $116 at the time of expiry.
In other words, the profit in dollar terms would be a net of 63 cents or $63 since one option contract represents 100 shares [($1 – 0.37) x 100 = $63].
If the stock falls to $100, your option would expire worthlessly, and you would be out a $37 premium.
The upside is that you didn’t buy 100 shares at $100, which would have resulted in a $15 per share, or $1500, total loss.
As you can see, buying call options can help limit your downside risk and earn an exponential profit.
To quote the famous Warren Buffet — “Don’t invest in something you don’t understand”.
Selling call options
Selling call options is known as writing a contract. The writer receives the premium fee. In other words, a buyer pays the premium to the writer (or seller) of an option. The maximum profit is the premium received when selling the option.
An investor who sells a call option is bearish and believes the underlying stock’s price will fall or remain relatively close to the option’s strike price during the life of the option.
If the prevailing market share price is at or below the strike price by expiry, the option expires worthlessly for the call buyer. The call option seller pockets the premium as their profit.
However, if the market share price is more than the strike price at expiry, the seller must either sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to the call option buyer.
The contract writer incurs a loss. How large of a loss depends on the cost basis of the shares they must use to cover the option order, plus any brokerage order expenses, but less any premium they received.
Let us consider the following example. Assume that Microsoft shares trade at $100 per share, and you feel that the value will not go beyond $115.
You decide to sell a call option at a strike price of $115 for 37 cents per contract. The net premium received by you is $37(0.37*100) considering 100 shares in a contract. Your profit is limited to your premium collected i.e $37.
If the shares rise to $116 and the premium becomes $1, you will be at a loss of $63 ($1 – 37 cents*100). If the shares rise further to $120, your option premium will increase by $4. Now you will be at a loss of $463 ($5 – 37 cents*100). This loss excludes the brokerage and order expenses.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The call buyer only loses the premium. The writer faces infinite risk because the stock price could continue to rise, increasing losses significantly.
Another Warren Buffet quote will be the aptest to describe the above. “Derivatives are financial weapons of mass destruction”.
Buying put options
Put options are investments where the buyer believes the underlying stock’s market price will fall below the strike price on or before the expiry date.
Since buyers of put options want the stock price to decrease, the put option is profitable when the underlying stock’s price is below the strike price.
Their profit on this trade is the strike price less the current market price, plus expenses—the premium paid and any brokerage commission to place the orders. The result would be multiplied by the number of option contracts purchased, then multiplied by 100—assuming each contract represents 100 shares.
The value of holding a put option will increase as the underlying stock price decreases. Conversely, the value of the put option declines as the stock price increases. The risk of buying put options is limited to the loss of the premium if the option expires worthlessly.
Consider that Microsoft shares trade at $110 per share, and you believe that the value will decrease. You decide to buy a put option to benefit from a decrease in stock’s price.
You buy a put option of $100 strike price for the current month expiry, trading at a premium of 37 cents per share. In case the stock price moves against you, your loss is limited to the premium you have paid i.e $37 (37cents*100)
If the stock price falls to $99 and the premium turns to $1, you are in profit of $63 ($1 – 37 cents*100). If it further falls to $89 then your premium rises to $10 and you will be in a profit of $1063. A profit of 2873%.
As you can see, buying put options will help you earn an exponential income during the falling markets with limited risk.
Selling put options
Selling put options is also known as writing a contract. A put option writer believes the underlying stock’s price will stay the same or increase over the life of the option, making them bullish on the shares.
If the underlying stock’s price closes above the strike price by the expiry, the put option expires worthlessly. The writer’s maximum profit is the premium.
The risk for the put option writer happens when the market’s price falls below the strike price.
The seller is forced to purchase shares at the strike price at expiry. The writer’s loss can be significant depending on how much the shares depreciate.
The writer (or seller) can either hold on to the shares or hope the stock price to rise back above the purchase price or sell the shares and take the loss. Any loss is offset by the premium received.
An investor may write put options at a strike price where they see the shares being a good value and would be willing to buy at that price. When the price falls, they get the stock at the price they want with the added benefit of receiving the option premium.
For example, Microsoft is trading at $110 per share, and you sell a put option of a strike price of $100 with a premium of 37 cents. Your profit is limited to your premium i.e $37.
If the price falls to $99, you will be at a loss of $63.
If the price falls to $89, you will either have an option to take a loss of $1063 or you can buy the shares at the strike price of $100 hoping the stock price to rise above your purchase price.
Charlie Munger, vice chairman of Berkshire Hathway, once said, “The world of derivatives is full of holes that very few people are aware of. It’s like hydrogen and oxygen sitting on the corner waiting for a little flame.”
One can earn in the falling market by shorting futures, buying put options, and selling call options.
“Making money consistently requires a lot of knowledge and experience. Beginners should be very cautious about taking trades in the F&O market without fully learning about the mechanism of investment and related risks,” Dr.Kamakhya Singh said.