Consider a situation where we have analyzed a particular stock and we believe that this stock will go down in its price in the next 2 to 3 months.
The below are some of the alternatives we have with us:
Sell the stock right now and buy it back at later date at lower price
Sell the stock futures and buy later at lower levels
Buy Put Options
Sell Call Options
Let us analyse each situation:
Sell that stock and buy back at a later date: If you have a particular stock in your portfolio and you feel that the stock price will go down in the near future, you can always sell that stock right now and buy back at a later date when the stock price corrects. This way you make a profit and also have saved your portfolio value to come down when the stock price crashes and at the same time you have the same stock in your portfolio at that later date.
Sell the stock futures and buy the same stock at a later date at a lower price:in case you don’t own the stock, but are bearish on a stock, you could sell that stock futures and buy at a later date to book your profit.
One could buy Put Option on that stock – such an option would give me the right to sell if I want, but not the obligation to sell. If the price of that stock is higher in the cash market on expiration date, I would not exercise my put option as I can sell in cash market for a higher price. But if the price has gone down in the cash market, I would definitely exercise my put option and sell at a higher price (strike price) and make a profit. Here the investment is upto the tune of premium amount needed to buy the put option.
Alternatively, one could sell call option – but this option gives you limited profit ONLY to the tune of premium charged upfront. When one sells options, one earns premium. This is the only inflow of revenues for the option seller, but the risk is too high. If the price of the underlying script goes down, the call option seller is safe. But if the price of the underlying script goes up in the cash market, the option buyer will exercise his right and buy from the option seller at that pre-determined lower price. Hence while the profit is limited (upfront premium) – the loss is practically unlimited.