March 3, 2014 by Liberty
Last year was a massive year for the stock market. After years of slow growth (at best), 2013 resulted in many companies developing major stock holder backing with prices rising dramatically. Not all is peachy in profit land though. It’s a little more complicated than that. Despite the stock increases, the economy is still in shambles. Real unemployment and underemployment is at ridiculous rates. Housing prices are still not even close to where they were. Most importantly, the federal reserve is still adding billions of dollars to the economy every single year.
Many of the stock market gains look solid on paper through a traditional lens but the scope needs to widen to account for the economy as a whole. Some of the gains in the market are good but there is no way to know how much of the gains being seen are real and how much of those gains are just being inflated by the federal reserve. That makes it a very dangerous time to be in the market.
Why People Invest Anyway
The majority of people still do not have faith in the economy in the United States. Despite that, people are still investing a large percentage of their investments in the stock market. There are three main types of doubting investors involved when a bubble is building like this.
The first kind of investor, the 401k investors, don’t have too many choices. They may see the dangers in the stock market but they don’t know what they can do about it. They may move some of their money international or change their allocation a little bit but they can’t make any major moves. When the money is in a 401k there aren’t too many options but to find a better allocation.
The second kind of investor is the “jump out” investor. They see the bubble building but they look at the profits they can make in awe. Watching the stock market rise every month can be a very enticing gamble to take. The jump out investors have this wild plan to ride the market out and then, at the first sign of crash, pull all of their money out. That means, ideally, they’d make the profit and not be invested in the crash.
The major problem with this plan is that you can’t time the market. There is no way to know when a real crash is coming and when, like a month or two ago, a short term decrease is coming. When the money starts running, it doesn’t mean the market is popping. A huge drop can be short term and it can recover in almost no time at all. If this is a full-time investors plan then it might work. It should not be the plan of the average investor.
The third kind of investor is the kind of investor you want to be. You want to be a hedging investor. Using stock options, you can ensure the downside of any stock purchase that you want to buy. That means, no matter what happens, you’ll never risk losing more than the amount you insure.
How To Hedge
Dealing with stock options can be a complicated business and it’s best to do some in-depth research before starting out. The general idea behind them is simple. An option is something you can buy that grants you the privilege of buying or selling a stock at a certain price within a certain time period.
Specifically, we’re going to be dealing with put options. Call options are pretty much the opposite.
If you were to buy 100 shares of ABC stock at $100 each then you’ll be investing a total of $10,000.
You can lose all of that $10,000.
With the stock market’s reasonable volatility right now, it can look like a total crash is almost impossible but the possibility is always there. If a major catastrophe happens, it is always possible for you to lose every penny. Even if you try to sell it first.
To protect that investment, you could buy a put option. A put option lets you sell a stock at a specific price no matter what happens to the market price. (On the other end of the investment, there is a person promising to buy it at that price no matter what.)
If you bought a Put option at $75 for ABC stock, even if the stock price drops below $75 you could still sell 100 shares of ABC stock for $75 each. That means, $7,500 of your investment is insured if you manage your purchase right. Everything that you lose off the stocks price dropping is regained in the options value.
The cost of a put is one of the number of things you need to worry about. You need to make sure that the put doesn’t cost more than a small percentage of your investment or you might end up eating away your potential stock market gains buying unused Put options. It’s all about balancing however much you’re willing to risk. (I usually aim for 85% insured.)
To make this a little easier, focus on purchasing dividend stocks that pay a higher dividend yearly than the cost of buying a yearlong put option at a set insured percentage.
Using this strategy, you can ride the profits of a bubble without putting your whole nest egg at stake.
Profiting From The Crash
There are millions of different ways you could pull a profit off of a sinking economy but options are some of the most powerful. Using different options strategies, you can make major bets on the economy for very little money. The vast majority of the time, these investments will not pay off. When these investments do pay off, they pay off disproportionately well. That, ideally, will make up for the losses.
Specifically, you don’t need to purchase stock to purchase stock options. When you buy a put option, you still have the right to sell the option later for just as much.
If you were to purchase the $75 put option for ABC stock without purchasing the stock and the stock price dropped to $60 you’d be able to sell the option to someone else for at least $15 a share. (or you could buy the stock for $60 and sell it for $75 instantly profiting $15 a share. That leaves you losing the extra market price for the time value though. (Simple version: Usually sell the option instead of exercising it.)
This is all a rather complicated subject for the average person but when you start to understand it you’re bound to start making some major changes to your investment strategy. This article isn’t intended to provide investment advice. It’s only meant to introduce you to the topic.
Using stock options you can insure your stock investments. That means, even if you’re bearish in the long term, you can benefit from the bubble building in the short term. Many of the fastest growing stocks today are also some of the riskiest bets in the long term. Using this strategy you can safely expose yourself to the dangers of a major crash and still be sure you get to reap the rewards.
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