How to minimize losses in a down market?

Whoever investing in stocks has experienced that. We all dreamed of becoming rich. But the wobble has caught us by surprise.

What to do? Do nothing and let it fall?

- If I sold it, the floating loss would be realized.

- If I held it, would the price keep going down?

- If I added my position to bring down the average cost, would the price still head down?

Many people think stock trading is all about "buy low and sell high". If you think that's all, you are underestimating our investing forefathers:

Here is a primer about options if you don't know what they are:

The strategy presented next is against the following background：

You are bullish on a stock for the long term, but this stock is currently in a downside channel. You don't want to leave the market and want to hedge against downside risk.

But this strategy does not apply to intraday arbitrage, high-frequency stock trading, etc.

- What is it:
Holding the underlying stock while simultaneously buying its puts to hedge against downside risks.

- When to use:
Holding the underlying stock with concerns about a near-term decline.

This approach is just like buying insurance for your holdings.

Normally, a put option can "protect" 100 shares of the underlying stock*.

Take Pinduoduo (PDD) for example

On the first day of one month, I bought 1,000 shares of PDD at $100 at the price of $100,000.

By the 15th, the price of PDD rose to $130, earning me $30,000. I was over the moon.

I expected the stock was likely to fall, but I didn’t have extra money to add position to dilute the cost of my position; at the same time, I still wanted to make some profits. So I set myself a psychological price, $110. If the stock dropped below $110 in a week, I’d still be able to sell my shares at $110, locking in a return of around 10%.

So on the 15th, I bought the puts at $3 with the strike price of $110 that would expire on the 20th next Friday. To fully cover my 1,000 shares, I'd need to pay a $3,000 premium for 10 of them.

By the 17th, I found out that the stock price had plunged to $80. OMG! What should I do?

If you only held the shares, you would lose (100-80)*1000 = $20,000. But I insured my 1,000 shares. What a relief!

I can choose to exercise my options.

So the shares will be sold at $110 and I'll get $110,000. Subtracting the $3,000 premium, I'll make a profit of $110,000 - $100,000 - $3,000 = $7,000. Look, I can still make money in a down market.

If you prefer keeping the stock, you can do the following.

I can also sell the puts to close the position.

Before the options expire, the falling stock may drive the put price up. Now suppose the put price has risen to $20, I can directly sell them to earn some money (because I do not want to sell the underlying shares yet). I can earn (20-3) * 1000 = $17,000. Of course, don't forget the loss from the underlying shares: (100-80) * 1000 = $20,000. So with the help of options, the original $20,000 loss can be narrowed to $3,000, enabling us to bear greater downward pressure.

When the option expires, you can follow the steps above. But if it's close to expiration, option 2 may not work because the options will lose all of their time value, unable to attract any buyer. So the only choice left is to exercise the options and sell the stock.

To avoid greater losses, here's a comparison between holding the stock only with buying married puts.

On the 17th, the share price fell to $80

1. If the stock price moves up after I bought the puts, I will lose $3,000 at most.

2. But I’ll gain from the price uptick, which can offset the cost of the option premium.

- What is it:
Holding the shares and selling the puts to bring down the average cost

- When to use:
Bullish on the stock for the long term with shares at hand

Suppose I’m a fan of AMD. I thought this company was a value stock and it was a good time to buy it in. But I was not sure how it was going to move short-term. So I chose to buy a few of the shares first.

On the first day of a month, I bought 1,000 shares at $100, costing me $100,000.

Later, AMD started falling, continuously.

Instead of panicking, I saw this as an opportunity. If it continued to fall to $90, I’d buy another 1,000 shares so that my average cost of the position = ($100,000 + $90,000) / 2,000 shares = $95 per share.

If there was no option, I’d have to wait until the stock price dropped to $90 before adding my position. But I could make use of options as I waited: selling puts and earning a premium.

On the 3rd, AMD shares fell again. At this time, I could sell the puts expiring on the 13th of this month with a strike price of $90 at $2. In this way, if 10 puts could be sold, I'd buy in 100 shares at $90.

Selling puts is like selling insurance. It promises the buyer that on the 13th, the seller, in this case, it's me, will buy 1000 shares of AMD at $90 from the buyer, no matter how much the stock price is. I'm not doing this for free. I need to charge $2*1000 = $2,000 for the "premium". When someone in the market buys this put, this "insurance" contract comes into effect.

1. Before the expiration date, if AMD falls below $90, then the put buyer will exercise the right. I need to fulfill the promise to pay $90,000 to buy 1,000 shares of AMD, but I still earn $2,000.
If I include the option gains in the cost of holding, my current cost of holding = $100k + $90k - $2k = $186k. So the average cost of each share is $93. Hooray!

2. If AMD does not fall to $90 before the expiration date as expected, the buyer will not exercise the right and I earn a $2k premium. Deal!

1. If you just get to know options, use them with caution. Theoretically, option sellers may take unlimited risks and get limited returns because the stock may keep falling, even down to zero.

2. The seller can face high risks and great volatility. So generally speaking, it’s not a good idea to sell puts that will expire a month later.

3. The examples given above are under specific circumstances. The seller needs to analyze the risks and benefits, and anticipate all possible future scenarios.

The chart below shows the possible scenarios.

If you are not bullish on a stock for the long term and are not ready to add your position, be careful about selling puts. An option can not only manage risks but also provide leverage. It can get considerable returns with a small amount of money, but it can also get you involved with unlimited risks.

The market is dynamic, both for stocks and options. Be careful, alert, calm, and decisive.

Or we simply don't know who will lose their shirts.

Holding the underlying stock but can't see through the market? We'll tell you how to navigate in the next chapter.