Most people are familiar with the concept of trading stock. I could cover what is stock and how it works, but let's jump right into the million dollar question. Why would a person want to buy stock? I think the average person would be able to tell you that by owning stock, you own a piece of the company. The idea, or hope, is that if the company makes money, the company will be more valuable and in turn the stock would be more valuable. You buy a share of stock for $100 and the stock goes up to $110. You sell your share of stock and you just made $10.
The average person's knowledge of trading probably ends there. Not only does this sum up the average person's knowledge of trading, but also this sole concept of buying stock is what the majority of peoples' entire retirements and 401Ks are based on. With just this one concept, if stock goes down, so does your portfolio and your retirement. The only way to make money buying stock is if that stock goes up.
To make your trading more versatile, besides buying stock, you could also short stock. Shorting stock is a way to make money if the stock goes down. (I do not personally short stock, but I do think it is important to understand how it works because it will make later concepts seem more intuitive) To better understand this, it might be easier to first think of it as the opposite of buying stock. Buying stock is also known as being "long stock." When you go long stock, you first buy it to open the position and then you sell it to close the position. When you go short stock you are first selling the stock to open your position and then buying it back to close the position.
This concept is more difficult than being long stock, because the question should come up, how could you sell something you don't own? And my answer would be, well, because you can. Think of it like this: Let's say a company's stock currently costs $100 per share. For whatever reason, you think the stock is going to go down, maybe because of a bad product, or bad service or poor business decisions. So you short the stock. For example, you sell 1 share of stock at $100. You now owe your broker one share of that company's stock that you will have to buy back. If the stock goes up, the cost to recover that one share of stock goes up, if it goes down, your cost to cover that share goes down. The next day or week or whatever, the stock now costs $90 and you decide to buy back your share. Congratulations! You just shorted stock and made $10!
This is good news. We now understand how trading, whether stock goes up or down, can make money! No longer are we dependent on a stock's upward movement to find ways that can book profits! But is that enough? Would you like to have more weapons in your arsenal of trading? I think that might be a good idea because to make money if a stock goes up or down can still be limiting. Although we have partially solved our initial problem of only being able to make money if a stock goes up, there are other things to be thinking about:
- Stock doesn't just go up or down, but also sideways. I want a way that would allow me to be able to make money when a stock moves sideways.
- Owning stock is expensive and requires a lot of capital. I want a way that would give me more bang for my buck.
- Owning stock is risky. What if I go long a stock and the stock price goes to zero? I want a way to hedge my risk so that I can limit and control exactly how much of my money is at risk before I even open a trade.
- Owning a stock takes too long. Stocks can move slowly and if they do, whether you are long or short it takes a long time for profit to be made. I want a way to take advantage and to profit not only from stock movement, but also from time.
Comments and Questions always welcome.
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