What's it called when you buy a stock betting it will do poorly

[bigred]

No I don't mean "masochism." I mean you buy it and if it does poorly, you gain - sort of an inverse purchase. I want to say "short sell" but not sure that's it....

[Huh-What?]

Shorting a stock

"Short sell" is from the real estate industry

[Wowbagger]

I think "short sell" is actually the term you are looking for:

http://en.wikipedia.org/wiki/Short_selling

[Sefarst]

Do you mean "shorting" a stock? It's not actually BUYING the stock, more like borrowing it and then rebuying it when the price goes down.

[bigred]

Wow fast response. Thx!

[rjh01]

In Australia it is called making a capital loss. Short selling is different from this in that the later is agreeing to sell stock in the future that you do not currently own. The former is buying stock at the current price and then watching the price going down, then selling the stock you do own.

[a_unique_person]

I like the logic behind 'averaging out your losses'. If I was a stock broker, I would love it if my customers believed that.

[JWideman]

Yep, that's short sell. Because there is a limited potential gain, and an unlimited potential loss, it's a risky move.

[The Atheist]

Originally Posted by JWideman

Yep, that's short sell. Because there is a limited potential gain, and an unlimited potential loss, it's a risky move.

No riskier than buying. And the loss is most definitely limited by a stop loss provision. No broker will allow potentially unlimited losses to stand, simply because if the punter defaults, the broker still has to pay.

[Francesca R]

Originally Posted by JWideman

Yep, that's short sell. Because there is a limited potential gain, and an unlimited potential loss, it's a risky move.

This is mathematically true but not practically so, since prices do not tend to "crash upwards" to infinity. Plus, one almost always has to hand over collateral to a broker when selling short, and also the broker will normally insist on having the legal right to close out your bet for you (in the event that they doubt your collateral can cover a loss).

[Bob Blaylock]

You don't buy something hoping it will lose value. As others have said, I would guess that what you are thinking of is “selling short”.

Imagine that you are certain a stock is going to go up in value; what do you do? You spend money, to buy the stock. If you're really sure that the stock is going to go way up, and you have good credit, you might even borrow money, and use it to buy the stock, expecting later to sell the stock at a higher price, pay back the money you've borrowed to buy it, and have some profit left over.

Selling short is the opposite of that. If you are sure that a stock is going to go down, what do you do? You sell it, of course. What if you are really sure it's going to go way down, and you don't have enough of it to sell? You borrow it. That is, you borrow the stock. Instead of owing money, now, you owe someone so many shares of that stock. Later, you hope that the stock goes down in price, so that you can buy enough shares of that stock at a lower price to pay back the stock that you borrowed, without spending all the money that you gained by selling the borrowed stock.

A somewhat less extreme way to profit from stock going down is through options. Options are basically the right, at some point in the future, to buy or sell stock, at the price that it is at now. If you think the stock is going to go up, you might buy “call” options on it, which entitle you, at some point in the future, to buy it at the current price. If the stock really does go up, then your options entitle you to buy it at the old price, whereupon you can then sell it at the new, higher price, and make a profit. The opposite option is a “put”*option, which entitled you, at some point in the future, to sell a stock at the current price. If you think a stock is going to go down, you'd buy put options on it; and if it does go down, you'd buy it at that lower price, then exercise your put option to sell it at the older higher price.

[Chaos]

Originally Posted by Bob Blaylock

A somewhat less extreme way to profit from stock going down is through options. Options are basically the right, at some point in the future, to buy or sell stock, at the price that it is at now. If you think the stock is going to go up, you might buy “call” options on it, which entitle you, at some point in the future, to buy it at the current price. If the stock really does go up, then your options entitle you to buy it at the old price, whereupon you can then sell it at the new, higher price, and make a profit. The opposite option is a “put”*option, which entitled you, at some point in the future, to sell a stock at the current price. If you think a stock is going to go down, you'd buy put options on it; and if it does go down, you'd buy it at that lower price, then exercise your put option to sell it at the older higher price.

Put options have fairly recently been featured in the latest James Bond movie. The bad guy bought a crapload of put options for an airplane builder company, and hired someone to blow up that company´s new prototype just before its presentation to the public. Talk about giving fate a little nudge...

But more seriously, the point of options is not to buy them like you would buy stocks. Their point is to use them to cover the risk of your stocks.
So, for example, you buy 1 MyCompany share for $100; one year later, it´s going to be between $50 and $150, with an even chance of it going either way. That means you´ll either make up to $50 or lose up to $50, depending on how the stock develops. That´s too risky for your liking, so you also buy a put option for MyCompany at a "strike" of $100 - so as Bob described you have the option of selling your MyCompany share for $100 in a year. Let´s say this option costs $5.
Now, if in a year, MyCompany stock sells for $150, you sell your share, get $150 and have made (include the $5 price of the option) a profit of $45 (instead of $50 without the option). If MyCompany stock sells for $50, you exercise your put option and sell for $100, so including the price of the option you lose $5 (instead of $50 without the option).

[Bob Blaylock]

Originally Posted by Chaos

Put options have fairly recently been featured in the latest James Bond movie. The bad guy bought a crapload of put options for an airplane builder company, and hired someone to blow up that company´s new prototype just before its presentation to the public. Talk about giving fate a little nudge...

I've only watched this one once or twice, and I think I remember that the villain had sold short. Either way, we've got the basic concept straight. A company was widely expected to have its stock go up as a result of the prototype aircraft it was about to unveil. Going against that expectation, the villain made a huge investment that counted on that company's stock to go down in value, and had one of his agents attempt to destroy the prototype in order to bring this about. The hero stepped in, stopped the saboteur, saved the prototype, and the villain was seriously screwed, compelling him to go on to an even riskier gamble, where our hero got another chance to screw him over yet again; which formed most of the plot of the movie.

[Francesca R]

Originally Posted by Chaos

But more seriously, the point of options is not to buy them like you would buy stocks. Their point is to use them to cover the risk of your stocks.

The point of them is to obtain a future return distribution that is different (as a function of the price of the underlying and as a function of other variables) from the distribution the underlying investment gives. There's no particular stipulation that options should be bought (or sold) to reduce risk.

Quote:

So, for example, you buy 1 MyCompany share for $100; one year later, it´s going to be between $50 and $150, with an even chance of it going either way. That means you´ll either make up to $50 or lose up to $50, depending on how the stock develops. That´s too risky for your liking, so you also buy a put option for MyCompany at a "strike" of $100 - so as Bob described you have the option of selling your MyCompany share for $100 in a year. Let´s say this option costs $5.
Now, if in a year, MyCompany stock sells for $150, you sell your share, get $150 and have made (include the $5 price of the option) a profit of $45 (instead of $50 without the option). If MyCompany stock sells for $50, you exercise your put option and sell for $100, so including the price of the option you lose $5 (instead of $50 without the option).

You make it sound as though the long stock + long put position has a better expected payoff than the long stock only position. I appreciate that you're just illustrating how options work with a specific scenario, but in reality, taking all future scenarios into account, the purchase of put options should not increase your ex-ante returns.

[Chaos]

Originally Posted by acuity

The point of them is to obtain a future return distribution that is different (as a function of the price of the underlying and as a function of other variables) from the distribution the underlying investment gives. There's no particular stipulation that options should be bought (or sold) to reduce risk.

That future return distribution is their function. My finance professor was very clear that their purpose is the reduction of risk. Just like a future return distribution is the function of stock, while their purpose is raising capital (for the issuer) and participating in the profit generated by a corporation (for the investor). Much of the trouble caused by either stocks or options stems from people using them as a way to gamble.

Quote:

You make it sound as though the long stock + long put position has a better expected payoff than the long stock only position. I appreciate that you're just illustrating how options work with a specific scenario, but in reality, taking all future scenarios into account, the purchase of put options should not increase your ex-ante returns.

Not if the option is priced fairly. Which it wasn´t, admittedly, in my example.

[Francesca R]

Originally Posted by Chaos

That future return distribution is their function. My finance professor was very clear that their purpose is the reduction of risk. Just like a future return distribution is the function of stock, while their purpose is raising capital (for the issuer) and participating in the profit generated by a corporation (for the investor). Much of the trouble caused by either stocks or options stems from people using them as a way to gamble.

Well I would advance that this was your finance professor's view. Non-linear derivatives like options allow risk (future return distributions) to be altered, priced and bought and sold. They achieve no net risk reduction overall, just risk transfer. I frequently use options to increase risk, at times when a convex or concave exposure to a financial price is preferable to me, which it can be for a number of reasons.

[Chaos]

Originally Posted by acuity

Well I would advance that this was your finance professor's view. Non-linear derivatives like options allow risk (future return distributions) to be altered, priced and bought and sold. They achieve no net risk reduction overall, just risk transfer. I frequently use options to increase risk, at times when a convex or concave exposure to a financial price is preferable to me, which it can be for a number of reasons.

Okay, I have to say that it was my understanding of the views of my professor. The finals results aren´t in yet, so I do not know how accurate this understanding is...

[jimbob]

There was the amusing fix that has since been banned in the UK.

A person floated his company (at around £20 milllion IIRC). He lade a massive (£2-million?) spread bet that the price was giong to rise, and the bookmaker took the bet, then bought shares in the company to cover the cost of the bet comming off. They bought sufficient to raise the share price...

Personally I think the bookmaker was foolish in taking the bet. And I can't recal many more details and the numbers are almost certainly wrong.

I must be channeling someone.

[devnull]

Either a short sell (selling stock you dont actually hold) or you could also buy a put option of some kind. Either of these would make you money if the price of a security drops.

Edit: Actually, you could also sell a call option.......

[DavidS]

Originally Posted by Bob Blaylock

Options are basically the right, at some point in the future, to buy or sell stock, at the price that it is at now.

Recognizing my exposure as a one-legged man in a butt-kicking contest, I offer:

Options are basically the right, at some future time or for some specified period of time, to buy (call) or sell (put) the stock (or whatever) at some agreed price (that may be arbitrarily different from the current price).

You can probably find somebody to sell you a $500/share put option for a stock that trades today at $10/share. You can expect that option to cost you $490/share, more or less; how much more or less will reflect (more or less) the current expectation that the stock will trade at $500/share during the option period. Ditto, more or less, for a $10 call on a stock that's now trading at $500.

Many (most?) options can be exercised at any time during their period, not just at one pre-determined magic moment. If I pay $490 to get that $500 put for the next six months and the stock drops to $5 tomorrow, I can buy shares to exercise my put and nail down $5 profits even if the stock rises to $12 the next day.
(It's possible I'm mistaken on this point, and that this appearance results from the net effect of other "hidden" transactions... but if they're hidden well enough that it reliably looks like that to me, I don't care.)

[Chaos]

Originally Posted by DavidS

Recognizing my exposure as a one-legged man in a butt-kicking contest, I offer:

Options are basically the right, at some future time or for some specified period of time, to buy (call) or sell (put) the stock (or whatever) at some agreed price (that may be arbitrarily different from the current price).

You can probably find somebody to sell you a $500/share put option for a stock that trades today at $10/share. You can expect that option to cost you $490/share, more or less; how much more or less will reflect (more or less) the current expectation that the stock will trade at $500/share during the option period. Ditto, more or less, for a $10 call on a stock that's now trading at $500.

Many (most?) options can be exercised at any time during their period, not just at one pre-determined magic moment. If I pay $490 to get that $500 put for the next six months and the stock drops to $5 tomorrow, I can buy shares to exercise my put and nail down $5 profits even if the stock rises to $12 the next day.
(It's possible I'm mistaken on this point, and that this appearance results from the net effect of other "hidden" transactions... but if they're hidden well enough that it reliably looks like that to me, I don't care.)

Option pricing is a lot more complicated than that (if I understand it correctly). Depending on the "strike" (the option´s "agreed price" as you call it) and the expectation of the person in the "short" position (i.e. the guy selling the option) the option is supposed to have a certain expected value. For example, if the strike is $100, and the stock is expected to have a 50% chance each of being at $50 and $150 in the end, then the option has a 50% chance of getting you $50 and a 50% chance of getting you nothing - or, in total, an expected value of $25. This expected value, discounted to the present at the risk-free interest rate (i.e. the amount of money you would have to invest at the risk-free interest rate in order to get back $25 at the point when the option matures), is considered the fair price for the option. The tricky part, as you might expect, is figuring out how the stock is expected to develop.

As for the point at which options can be exercised, there are two kinds of options. "European" options can only be exercised when they mature, "American" option can also be exercised at any point prior to that.

[Francesca R]

Originally Posted by Chaos

As for the point at which options can be exercised, there are two kinds of options. "European" options can only be exercised when they mature, "American" option can also be exercised at any point prior to that.

As far as I know American style options are somewhat more widely used. Note that although European style ones cn only be exercised at expiry, this in no way locks the buyer or seller in for the lifetime of the contract. European options can be traded, just not exercised, any time up to expiry.

Most American options are not exercised before expiry because time value is always greater than zero. Exercise cancels time value, whereas selling the option unexercised allows it to be realised.

[Chaos]

Originally Posted by acuity

As far as I know American style options are somewhat more widely used. Note that although European style ones cn only be exercised at expiry, this in no way locks the buyer or seller in for the lifetime of the contract. European options can be traded, just not exercised, any time up to expiry.

I would assume, from the name, that American options are most common in the US and European option are most common in Europe. I wonder which one other major markets (Japan, mostly) have primarily adopted.

Quote:

Most American options are not exercised before expiry because time value is always greater than zero. Exercise cancels time value, whereas selling the option unexercised allows it to be realised.

True. Nevertheless American options are preferable to European ones, ceteris paribus, due to the possibility of exercising them.

By the way, you might want to print this post out and frame it; I´m actually admitting outright that something American is better than its European counterpart... we are living in an age of miracles.

[Francesca R]

Originally Posted by Chaos

I would assume, from the name, that American options are most common in the US and European option are most common in Europe. I wonder which one other major markets (Japan, mostly) have primarily adopted.

No, it has nothing to do with that. American options are more widespread in Europe too. And Japan. The exception to this is over-the-counter options (not traded on exchanges), which are mostly European-style. Currency options are mostly OTC so they are mostly European-style wherever they are transacted. I don't know where the names "American" and "European" came from in respect of options.

Quote:

True. Nevertheless American options are preferable to European ones, ceteris paribus, due to the possibility of exercising them.

Yes but that's why they cost more.