But more specifically, who are the people on the other end losing all of this money so you can gain out of a sinking stock?
My understanding of shorting is basically you see a stock priced @ $100. You make a bet that it will drop to say $50 and someone commits to buying it at $100. When it goes to $50, you buy it for $50 and the buyer has to buy it from you for $100. Is this correct?
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Close, but not quite
Let’s follow that same scenario. You think that $100 stock is going to fall. So you borrow 200 shares from somebody that already has that stock and sell it for $20,000.
Now, when the stock falls, you buy 200 shares at $50 dollars a share for $10,000. You then return those stocks back to the person you borrowed them from.
The risk is that the stock may go up, and the loaner of the stocks may want them back. Meaning you may have to buy those stock at $150 per stock for a total of $30,000 to give them back.
More or less correct. What you’re missing is buying a put or a call option has a cost (called premium), and that’s how the other side (the option seller) makes money.
Basically when you buy a put, you buy the right to sell a stock at a certain price (say $100) 1 month from now. The put seller, or the other guy, charges you say $10 for this right.
This has two outcomes:
A. Stock price at one month from now is $150. You don’t use your right to sell at $100 because why would you when market price is $150? But you already paid $10 for the right so the other guy gains $10
B. Stock price at one month from now is $50. You use your right to sell to the other guy at $100 so the other guy loses $50. But you also already paid $10 for the right so the other guy’s net loss is $40
I traded stock options for 20 years.
The difference is that I didn’t care what direction the stock would go. I would usually bet on the price of the option being too high (or low) and sell it (buy it). Then hedge with stock.
So, all day I’m trading options vs stock vs other options. Generally I was pretty flat the overall package. Small stock moves didn’t affect the overall portfolio.
Does that help?
A “call” is when you call a stock broker to ask for advice. A “put” is when you put the phone down and hang up because you realize you shouldn’t have asked for stock advice. Then you invest in index funds.
Shorting is basically like getting a loan from the bank, except instead of borrowing money, you’re borrowing shares of a stock.
To short a stock, you borrow 5 shares of the stock, it’s currently trading at $20. You sell the stock immediately and get $100. Later, the price drops to $10. To pay back your loan, you buy five shares for $50 and return it to the bank. Your “loan” of five shares of stock is repaid, and you made $50.
Hey OP this is not an answer, but if you came here because you are interested in trading options, i say DO NOT, i repeat DO NOT start trading options until you have at least a few preferably a few years day trading or practice with paper accounts. Volatility is near all time high and all options are priced for insane movements, you can easily lose like 60% value in a single day if you don’t know what you’re doing (heck it happened to people who know what they are doing). Or actually don’t do it until the current administration is out of office because it is too unpredictable to trade on anything but technicals right now
Buy calls = I think stock price will go up. You pay
Sell calls = I think stock price will go down. Get paid
Buy puts = I think stock price will go down. You pay
Sell puts = I think stock price will go up. Get paid
> Who are people on the other ends losing all of this money
The person selling the options is like an insurance salesperson. Much of the time, the option expires without being exercised, and they pocket the money paid for the option. If the option is exercised, they need to pay out.
The more likely a payout, the higher the risk, and the higher the option price. Some name a selling options strategy as “collecting pennies in front of a bulldozer”.
Alice buys a Call Option from Bob:
Alice pays Bob a $25 fee right now (called the Option Premium – doesn’t have to be $25, that’s just an example number). They agree on a stock, price, and date (ex. Reddit, $100, July 11).
At any point, on or before July 11, Alice can call Bob and tell him “I want to buy one Reddit stock from you for $100”, and Bob has to comply. No matter the current market price for Reddit. This is known as Calling, or Exercising the Call Option. If Bob doesn’t have the stock on hand, he must purchase it on the open market immediately.
Alice still has the option – hence the word Option – to simply not use it and let it expire. She paid the Option Premium, she’s the one who gets control.
Note that she can only exercise the option once. She can buy more than one option from Bob, and exercise them one at a time, but each one can only be used once. She can also buy Reddit from Bob – or from anyone else – at the regular price without exercising her option.
Now, the opposite. Bob buys a Put Option from Alice:
Bob pays Alice a $25 Option Premium. They agree on Reddit, $100, July 11.
Now, on or before July 11, Bob can call Alice and say “I want to sell you one Reddit stock for $100” and Alice has to comply. This is known as Putting, or Exercising the Put Option.
All the same details apply as above, it’s just this time it’s the seller that can force instead of the buyer.
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It’s a bet on a stock, ultimately. The one selling the Option and collecting the Premium is hoping the premium will offset any loss from buying high or selling low. The one buying is hoping that at some point, they’ll be able to make a big enough profit off of exercising the option to offset the premium.
Every option contract has 2 sides. The buyer and the seller. In a call contract, the buyer has a bullish (positive) outlook on the underlying asset, and the seller has a bearish (negative) outlook. In a put, the buyer is bearish and the seller is bullish. There are some trading strategies which may alter this, but for now let’s just assume the typical view above. Every contract has a premium, a small fee to purchase the contract, which is how the seller profits, assuming the option expires worthless
In a put contract, the buyer has the option to sell x amount of the underlying (for stocks, usually 100 shares) to the seller at a set price (called the strike price). Say you bought a put contract with an underlying asset price of $50, and this drops to $40 at the expiry of the option. You can now sell 100 shares of a $40 stock to the seller for $50, causing a $1,000 gain, less commission/premium/etc.
A call contract is just the opposite. The buyer has the option to purchase x amount of underlying asset for the strike price. If you buy a $50 stock that goes to $60 at the expiry of the contract, then you can purchase 100 shares worth $60 each for just $50 per share, allowing you make $1000 profit, less commission/premium/etc.
An important thing to note is the professionals taking the other side of the trade will put on yet another trade to remove their risk.
Simplistic model:
You buy a put from a professional trader and pay the premium. You will now benefit from the price going down.
Professional trader immediately borrows the same stock from someone else and sells the stock (short selling). Professional trader loses money on his short put and makes the same money on his short stock when prices go down, and pockets your premium.
The amount of stock the professional trader sells is based on option delta (which would make this model less simple), but basically the above is what happens.