The stock market is a great way to grow money over time. The market allows everyday people to own a piece of a multi-billion dollar business. And potentially benefit if the business succeeds.
However, how is it really possible to make money in the stock market. Here are the most common way to earn cash.
1) Short Selling Stocks
This first one is pretty for advanced in the market. However, an understanding on this one just shows you that there is a lot of opportunities in the stock market.
Basically, short selling is the opposite of traditional investing. You can make money on short selling when stocks go down. On the other hand, short sellers loses when a stock go up.
When a stock go down 50 percent, profits from short selling is 50 percent. However, the most money that can be made on short selling is 100 percent (double). It only happens when a stock go bankrupt.
On the other hand, the potential loses are technically infinite. For example, if a stock go up from $30 to $200, loses are $170 which is 5 times the original investment.
For the most part, beginners should stay away from short selling. The maximum return is 100 percent, but the potential loses is unlimited. Short selling can be considered when you have at least 3 years of experience in investing.
How Short Selling Works
Let us say a stock is trading at $100. The short seller borrows a stock from someone who owns it. Then, the short seller will sell the stock to get $100. If the stock go down to $80, she will have the option to purchase the stock.
If she purchased back the stock at $80, she will return it to the borrower for a $20 profit. Also, there can be some expenses to it like interest rate. Let’s say that it took a year for that to happen, and a total interest rate is $7 (7 percent). If that’s the case, the profit is $13 per stock.
On the other hand, let us say that the stock go up to $120 after a year. For whatever reason, the short seller decides that the stock will go up. She will decide to buy the stock at $120. Overall, the loss is $20 plus interest expense if this is the case.
Basically, short sellers borrows a stock. Sell it. Then buy the stock back at some point to make profit or loss.
Short selling can be dangerous. Some stocks can go up from $10 to $100. If that’s the case, the loss will be $90 per stock which is 9 times the original investment. On the other hand, the maximum income is $10.
Also, it takes a lot of time for a stock to go bankrupt. Short sellers may have to wait a long time even if she was right.
For the most part, short selling is not for beginners. There is a lot of much better ways to profit if you believe a stock will go down. It is called put options, will be discussed later in this article.
We now realize that money can be made from stocks whether it goes up or down. That’s why the stock market is full of opportunities. There is money to be made if done the right way.
2) Investing in Stocks – Dividends and Capital Gains
Buying stocks is the most common way to profit from stocks. There are two ways to profit: dividend income and capital gains.
2A) Dividend Income
Some stocks pays cash by simply holding their stock. It is called dividends. Dividends can be paid out either quarterly (every 3 months) or monthly. Most stocks pays quarterly dividends.
There is a a specific date called record date. That’s when you have to own the stock to receive dividends. Even if you sell after that date, you’re entitled to that dividend.
How Much Can You Earn From Dividends
A decent dividend rate is 4 percent (one year). For example, Let us say a stock is worth $100 when you buy it. The 4 percent of $100 is $4, that means it pays $4 on a year. It is equivalent to $1 per quarter ($4 divided by 4) or $0.33 per month ($4 divided by 12).
Whether the stock go up or down, you will continually receive that dividend income as long as the company chooses to do so.
Most of the companies pay around 2 percent dividends. Dividend yield is always measured per year. Quarterly dividends is the yearly rate divided by 4, while monthly dividends is the yearly rate divided by 12.
In the short term, dividend income is not that much. Let us take the stock on the example above. The $100 original investment only generates $4 in dividends at 4 percent yield. It is not a lot. But it adds up in the long run.
Mcdonalds was only paying $0.70 on dividends per quater on 2012. Today, Mcdonalds is paying $1.25 per quarter which translates to $5.00 per year. Most companies raises their dividends as long as the business is doing great.
Why Not All Stocks Pay Dividends
Dividends are cash paid from the company. Companies will have less cash after paying a dividend. That cash could have spent to grow the company.
Having cash is really important when a business is growing rapidly. That’s why most growth stocks do not pay dividends. Most companies that is not growing in revenue does pay dividends.
Also, companies that is growing is more likely to lose money. For instance, Uber is losing billions of dollars in its first years. At the time, they simply could not afford to pay dividends. And paying dividends does not make any sense for Uber.
On the other hand, Apple is earning billions in net income in every year. Apple is investing in a lot of stuff for future growth. Even after that, they still have a lot of cash. That’s why Apple is paying dividends.
Are High Dividend Stocks Better
High dividends are not necessarily guarantee a better investment. In fact, dividends that pays more than 5 percent dividend yield can be unsustainable. Great dividend stocks typically pays between 3% to 5% in dividend yield.
Some companies pays around 10 percent in dividends to attract more investors. However, these companies are more likely to cut their dividends in the future and decline in share price.
At the end of the day, dividends reduces the cash balance of a company. In order to increase their cash again, they have to earn income. Dividends can be justified and sustainable if they earn enough income to pay for it.
One helpful measure is called payout ratio. Payout ratio is the how much of net income is going to dividends. For example, let us say a company has earnings per share (net income) of $10. And pays $5 in dividends in a year. That means they have a payout ratio of 50% since they paid half of their net income to shareholders.
Generally, payout ratio of more than 100% is a red flag. The lower payout ratio, the better. A payout ratio of less than 70% is decent enough as long as the business do not change.
Another way is through P/E ratio. Simply divide 1 to the P/E ratio. The result is the maximum dividend yield they could pay through earnings. If the result is smaller than the yield, it may be a red flag.
For example, let us say a company has P/E of 10 and dividend yield of 5%. We calculate 1 divided by 10 (PE ratio), the result is 0.10. In percentage, 0.10 is 10% (0.10 x 100). Since 10% is more than dividend yield of 5%, earnings are enough to pay the dividends.
Is Dividend Income Forever
The dividends depends on the company. Just remember that the management can remove or decrease the dividend at any time they wanted to. But if a business is doing great, there is no reason to cut dividends.
Dividends may be cut for two main reasons:
- Business can’t afford it anymore (no cash)
- Business try to grow the business
Coca-cola has paid dividends for decades now. While some companies does not declare dividends anymore.
2B) Capital Gains
Capital gains is the more common way to make money in stocks. Obviously, you have to sell the stock in the future for higher price. The difference is the profit.
Let us say we bought a stock that is worth $150. After a year, everyone thought that the business has huge potential to grow. Thus, the stock price now trades at $250 per share. If you sold it, that’s a $100 profit per share.
If you bought 10 stocks, that is a $1,000 profit ($100 x 10). Pretty simple.
The question is how long should we wait before selling the stock. There are many strategies in how to invest. For simplicity, here are the 3 most common:
- Day Trading – holding a stock for 15 minutes to couple of hours
- Swing Trading – holding a stock for a couple of week to months
- Long Term Investors – more than 2 years
Day Trading
Day trading can hold a stock as little as 5 minutes to a couple of hours. Most day traders sell their stock before the day end. The more common way day traders use is by options (#3 – see below).
Day traders sometimes buy and sell stocks. When they do, they only hold it for little time.
Pros
- Quick way to make money
- Potential to double or triple capital in less than a month
- You can choose to take a day off anytime
Cons
- More than 95% of day traders lose money
- Takes at least 5 hours of work a day
- Emotionally stressful
- No guarantee to make profits
- Argument could be made that this is Gambling
Most people should not be day trading. Less than 5% actually make money in day trading. And there is no guarantee you could make lots of money, even if you are one of the 5%.
Day trading takes a lot of time and emotionally stressful. Basically, day trading could consume your emotions. Imagine losing $2,000 in a single day and imagine gaining $2,000 the next day. That’s what day trading feels like.
If you proceed anyway, try to start with a small capital. That way, loses are minimized.
For the most part, day trading is not for beginners. Try to start with much less riskier strategies first like swing trading.
Swing Trading
Swing trading is basically buying a stock (or options – later discussion) in hopes to sell higher for a profit. Swing traders hold a stock for a couple of weeks to several months.
They look for technical charts and try to predict a huge move. Also, they sometimes look into fundamentals of a business. But for the most part, it is heavily reliant to the price movements of a stock.
After looking a lot of charts, they could make a decision of that and predict that what is happening in a stock is similar to what heppened on a diferent stock brfore.
For simplicity, think swing trading of something in between of day trading and long term investing.
Long Term Investing
For most people, long term investing is the way to go. Among these 3 ways, long term investing is the least risky when it comes to investing.
Long term investing is basically the buy and forget strategy. Stocks are bought when you think it is undervalued. The strategy is to wait the business to grow. After a couple of years, the stock will hopefully rise.
Long term investors do not worry in the short term price swings in the market. They will be in the market through the good days and the bad. It is proven that the risk of losing decreases the longer you stay invested.
The market (S&P 500) has returned an average of 10 percent per year on average. On any 15 year period, there is 96% chance of positive returns. On the other hand, there is only 67% chance of having positive returns in 1 year.
Long term investing could also be combined with dividend investing. Dividends does matter in long term. In the short term, dividends is very little that it doesn’t matter that much.
Warren Buffet’s investing strategy is long term. He buys stocks and will not sell it for more than 20 years. Some long term investors holds a stock for 3 to 5 years. There are levels to this. If you’re a beginner, the most important thing is to actually get started.
Long term investing has returned a lot to investors. For example, a 200% returns or 500% returns just does not happen in less than a year. In long term, returns are added.
Also, it is not that hard to be a long term investor. On 2012, Facebook is a very famous company. Almost everyone knows Facebook at that time. The share price was worth $38 at that time. After almost a decade, shares are now priced at around $200 per share. That’s a 400% returns on investment.
It is a proof that you do not have to invest in a business that you do not have idea about. You can actually invest in a business that you know and still get great returns.
Also, Apple was worth around $100 per share on 2016. At that time, everyone knows what Apple is. Fast forward 4 years, Apple has returned 200% to its investors.
By taking that point of view, investing in stocks is made simpler and not complicated. Of course, no business is guaranteed to succeed. But it shows you that there is opportunity in investing in the stock market.
After all, investing in stocks is not rocket science. You do not have to have lots of money to start. A $1,000 capital in the market is more than enough to be an investor. And you buy stocks on your phone or computer.
To get started, here are the 5 Simple Steps to Start Investing with Little Money.
3) Options Trading
Options trading is a more advanced stuff. It is recommended to have at least 3 years of experience in the market before starting options.
Options is a contract that gives you the option (but not the obligation) to buy or sell a stock at a particular price. Options expires and becomes worthless after a particular date.
Day traders uses options more often than straight up buying since it gives higher returns. Options can be used by long term investors as an insurance.
Options trading offers great returns but a lot of risk. It is possible to 10 times or 20 times your cash in less than a month by using options.
One option contract is worth 100 shares. If an option trades at $10, that means one contract is $1,000.
Basically, there are a lot of ways to make money in options. For simplicity, let us discuss the two most common: buying call options and put options.
- Call Option – Stocks should go up to profit
- Put Options – Stocks should go down to profit
Call Options
Buying a call option is a bet that a stock will go up a lot. To better understand, let us look at the example below.
Options, by the name itself, gives you an option to buy or sell a stock at a particular price before the expiration date. If you have a call option with a strike price of $200, that means you have the option to buy the stock at $200.
If a stock is below $200, why would you buy the stock. On the other hand, if a stock trades at $250, you can exercise the option and purchase stocks at $200. And immediately sold it at $250 for a $50 profit.
That’s how options works in a nutshell.
Let us say a stock is trading at $120 per share. A call option may be available with a strike price at $150 that will expire in a year. Let us say that option is worth $10.
There are 4 scenarios at the expiration date (a year after in this example):
- If a stock trades below $150, the option is worthless. Thus, all investment is lost.
- If the stock trades at $160, there is no profit or loss. You will get $10 for each option ($160 – $150). You’ll get back $10 investment.
- If a stock trades at $200, the profit is $40 ($50-$10) per stock or $4,000 per option contract. You will get $50 for each option ($200 – $150) with a capital of $10. That’s 5 times the original investment.
- For some reason, let us say the stock trades at $300. You will get $150 ($300-$150) for each option. Minus $10 of original investment, the profit is $140. One option contract (100 shares) will be worth $15,000 , 15 times original investment of $1,000.
Options vs Buying a Stock
Let us say take the fourth scenario for example. To recap, a stock is trading currently at $120 per share. An option contract that is worth $10 with a strike price of $150 will expire in a year.
Pros of Call Options
Let us say that the stock go up to $240 per share after a year. On straight up buying the stock, that is a 100% income ($120 to $240), which is great.
However, call options has returned 800% of original investment. The option can be exercised to take a $90 income. By buying a stock at $150 (strike price) and selling it at $240, $90 difference. The original investment of $10 became $90, 800% gain.
When the stock doubles to $240, options has returned 800% gain while straight up buy only returned 100%. However, there is a disadvantage, mentioned below.
Cons of Call Options
What if the stock stayed at $120. On straight up buying, there is no gain or loss. On the other hand, the option became worthless. (Stock at $150 or below, option is worthless.) Thus, a 100% loss.
For the most part, options is a high risk bet. Most beginners in the stock market should not even consider options. After 3 years of experience, you may start looking into options. But it is highly speculative.
Notes:
- Call options are worthless after expiration date. Also, options tend to decrease in value as time pass by.
- The market decides what an option is worth. Day traders tries to find “undervalued” options.
- Options can be better than straight up buying when a stock go up a lot. However, options is worse than buying a stock when it expires worthless.
Put Options
Put options is the second most popular kind of options contract. It is the opposite of call option. When stock goes down to a specific price, that’s how to make profit on put options. When a stock is above the strike price, put options is worthless.
Put options is considered to be a better alternative to shorting a stock. In put options, the maximum loss possible is 100%. While losses could be infinite on shorting a stock.
Also, put options can return 1,000% or more. While shorting a stock can only return up to 100% of original investment.
Put options can expire in a week, a month, or a year. Generally, longer term options is more expensive.
However, put options expire while shorting a stock do not expire. For better understanding, let us take a look at an example below.
Let us say a stock is trading at $120. A put option has a strike price of $90 and the put option is bought at $10.
These means…
- If a stock is above $90 at the expiration date, the option is worthless. Thus, losing 100% of investment.
- If a stock trades at $80, it is a break even and no profit or loss.
- If a stock trades at $40, it will give a profit of $40 per stock. $50 minus $10 of original investment, a 400% profit.
Mixture of Call and Put Options
Most traders are basically using a combination of put and call options to hedge risk. A lot of day trading strategies have different calls and puts with different expiration dates.
Take note that only a few day traders actually make money. Less the 5% of day traders did not lose money on trading.
If you are a beginner, start with straight up buying and selling a stock. Options can be used after a couple of years of experience. Also, it is not necessary to use options to be a successful investor.
Warren Buffet rarely uses options. But I bet he understands it. A basic understanding of options is more than enough for beginners.
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No business is guaranteed to succeed. That’s why all investment has its own risks. However, taking safe investments will only give around 1% or 2%. In today’s interest rates, learning about investing can make a huge difference in the long run.
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