Written by Ze Yuan Fu, BEng. Comp Eng, McGill University Faculty of Engineering
Edited by Bhromor Rahman, MWR Editor-in-chief
Editor’s note: Ze Yuan Fu is not a certified fiduciary and cannot be held responsible for any losses the reader may incur should they invest in financial instruments. Always perform due diligence when purchasing financial instruments to minimize the chances of loss and spend responsibly. However, he did complete Vitaly Terekhov’s comprehensive finance course with an A+.
Introduction: Welcome to Wall Street!
The stock market is a place of wonders. Money changes hands at the speed of light, rags can become riches and riches often become rags. All this can occur in a matter of minutes (or even seconds) between the individual heartbeats of traders on the floor. Welcome to Wall Street, where fortunes are made, and the smallest of margins is the distinction between a life of opulence and losing everything!
What is the stock market?
If you’ve never heard of the stock market (or taken Dr. Terekhov’s wonderful Intro to Finance course like I did), it is the medium through which buyers and sellers come together to trade shares, or stocks. Each stock represents a portion of a company, albeit an infinitesimally small one. For example, as of the time of writing of this article, one can purchase a share of Amazon.com, Inc. for USD $3,190.02: this small investment nets you approximately one five hundred millionth of the company. Not all companies’ shares are priced that high, however. Many well-known corporations trade for under one hundred dollars per share, including Dell, General Motors, and Uber, just to name a few.
One thing that all publicly traded companies have in common, though, is that they all have a very large quantity of outstanding shares, i.e. shares that are currently in circulation, ranging from hundreds of thousands to hundreds of millions. This makes it very hard for the average Joe like me and you to outright buy an entire company; acquisitions like these are generally limited to institutions and large corporations.
How do you make money from stocks (or stonks)?
The conventional way of making money in the stock market is via pure capital gains, where one purchases shares of a company whose stock they believe will increase and sells these shares when they do. The resulting gain is simply the price difference at any given time multiplied by the number of shares purchased.
For instance, let’s say I bought 100 shares of Tesla Inc. (ticker: TSLA) – a very popular “meme stock”, more on that later – for $500 apiece. The next day, Tesla announces that they are officially starting production of their new Cybertruck, which causes the price of Tesla shares to increase to $550. If I were to sell these shares immediately, I will have made $50 * 100 shares = $5000 in profit. If I choose to hold these shares, though, I can potentially increase my open (potential) profit until I sell.
Every coin has two sides though, and the stock market is no exception. One can lose money as easily as they make it. If the price of a share falls after purchasing it, you will have lost the price difference multiplied by the number of shares you own. In the previous example, just let the final share price be $450, which yields a loss of $50 * 100 shares = $5000.
Despite how my description of earning and losing money may sound, any capital gains or losses are not locked in until you close your position (i.e. sell your shares). As long as the shares are still in your possession, it is possible for their value to increase or decrease with market conditions, (un)favorable news or otherwise. What may initially seem like a loss could in fact turn into a gain if Lady Luck smiles upon you.
I am quite ambitious, is there a… faster way of making money?
I am very glad you asked, because Ze Yuan gege has just the thing for you.
Options contracts, also knows as “options” for short, are a form of financial derivative (a financial instrument derived, hence the word, from its underlying stock) that makes money not via actual capital gains, but by betting on the direction of a stock’s price.
There are two types of options contracts: calls and puts.
-The buyer of a call option pays a “premium” in exchange for the right (but not the obligation) to purchase the underlying stock at a given price, called the “strike price”, before or on a given date, called the “expiry date”.
-Conversely, the buyer of a put option pays the premium for the right (but, again, not the obligation) to sell the underlying stock at the strike price, before or on the expiry date.
Options contracts can be redeemed, or exercised, at any time before the expiry date, but this will usually happen when the contracts are in the money (ITM): when a stock’s market price is higher than the strike price of a call option, or lower than the strike price of a put option. Otherwise, the option is out of the money (OTM) and exercising it will result in a net loss.
More about options
Let’s clarify this with the example I gave earlier. I think that Tesla Inc. is undervalued at $500 (i.e. I believe Tesla Inc. is worth more than $500 per share, and that the market will adjust the price towards the correct valuation), I bought a TSLA call option with a $520 strike price for $10. The next day, Tesla announces that they are officially starting production of their new Cybertruck, which causes the price of Tesla shares to increase to $550. Here, if I wanted to close my position immediately, I would have two possible courses of action.
First, I could exercise the option, which would yield a net gain corresponding to the difference of the market price of the stock and the strike price and then subtracted by the premium I paid for the call option in the first place: ($550 – $520) – $10 = $20. This net gain may seem worse than if you had just bought Tesla shares, but it increases as the difference between the market and strike prices increases, and allows you to purchase shares to hold for potential gains in the future.
Secondly, I could sell the option, which is now in the money (ITM), on the stock market. The price of ITM options varies from one stock to another, but is generally equal to the difference between the market price of the share and the strike price, plus an additional premium (which is not the same premium as the one I paid to purchase the option contract) that increases with the time left before the option’s expiry date. For simplicity’s sake, we will ignore the time premium and say that the TSLA $520 option I bought is now worth $550 – $520 = $30. Some 4th grade math will tell us that by going from $10 to $30, the option contract has tripled in value and by selling it, I will have cleared a profit of $20, which represents a return of 200% over my initial capital.
The potential rate of return is exactly the appeal for investors with higher risk tolerance than the norm. For example, an ambitious investor might have bought $5,000, and not $10, in TSLA $520 calls in this exact situation, and will see that initial investment turn into $15,000. Moreover, if you do not have sufficient capital to purchase shares, options contracts are a lower-cost alternative that can potentially offer similar, if not better, returns than investing in shares only.
Investors are not limited to purchasing options contracts; they may also sell, or “write’’ them. Selling contracts implies that you have the opposite sentiment of that option: writing a call means that you think the price of a stock will decrease and writing a put means that you think the price will increase. The reasoning behind this is fairly straightforward:
-If you write a call option and the price of the stock decreases, the holder of that call option has no reason to exercise it and will let it expire, which means that you get to keep the premium the buyer paid.
-Likewise, if you write a put option and the price of the stock increases, the option will also not be exercised and the premium is kept as well.
The following is a sample from part of my personal investing portfolio. The first shows my returns from investing in stock and the second shows my returns from investing in an options contract. Compared to my option contract, whose value octupled, the gains from investing in stock appear meager while requiring a larger initial capital.
Of course, the law of equivalent exchange also applies to options too. With the potential for very high returns, comes the potential for very high losses. Unlike stocks, whose value may fluctuate during a trading day but will rarely drop significantly, options contracts have no inherent value. Favorable market news might cause a price jump, and unfavorable news could reduce these contracts’ value to literally pennies. Writing options can also go wrong: if the price of a stock does not move in the direction you had expected, you will be obligated to buy or sell the underlying shares, incurring a loss in the process. All in all, options are a double-edged sword, which is why they are recommended for seasoned investors only.
Alright, but you mentioned those “meme stocks” earlier…
Ah yes, meme stonks. But how could the two have anything to do with each other? To understand the meme stock, we must first understand the meme:
The key phrases here are “fad” and “spreads by means of imitation”. A classic meme stock is Tesla Inc., whose share value increased 6.68-fold from USD $86.05 at the beginning of this year to USD $575.00 at the time of writing.
Despite the ridiculous gains of such a meme stock’s value, the underlying companies might not actually be considered a sustainable investment. In this case, Tesla Inc. shares are worth USD $575.00 while having only delivered 145 036 vehicles in Q3 (third quarter of) 2020. For comparison, the more mature General Motors Company is worth $45.63 per share with 665 192 vehicles delivered in the same period. Although it is true that GM has ~30% more outstanding shares at the end of Q3 2020 than Tesla, it is not enough to make up for the 12.6-fold difference in share price.
If you are a more seasoned investor, you may have heard of and invested in more recent meme stocks, such as NIO Inc. (ticker: NIO), Xpeng Inc. (ticker: XPEV), Corsair Gaming Inc. (ticker: CRSR), GameStop Corporation (ticker: GME) and Palantir Technologies (ticker: PLTR). All four of these stocks have seen extraordinary growth over the past few weeks due to a combination of investor hype and media attention.
Consider the price chart of NIO Inc.: the stock price has been hovering at around USD $20-21 until in mid-October which caught the eye of a few financial analysts. Shares jumped 30% overnight and after stagnating for a few days, fueled by hype from online forums and retail investors, started growing in a y = mx + b fashion, i.e. linear growth. In around a month, share prices peaked at USD $57.20 and might go even higher, pending a short period of respite.
What forums are you talking about?
Many online forums dedicated to investing exist, but the one I will go in-depth about today is a subreddit (Reddit forum) called /r/wallstreetbets. This forum is one of the main breeding grounds for meme stocks and discussions thereof, memes about meme stocks and anything else one could possibly imagine.
Although the number of memes heavily outnumber legitimate discussions about investing, users create DD, or “due diligence”, posts about stocks that they believe will go up or down in the near future. Other users will post “gain/loss porn”, which are screenshots of their respective trading platforms showcasing their gains and losses, respectively and so on.
Despite the entertainment value that forums like wallstreetbets offer, it is inadvisable to actually take the investment advice offered there since few DD posts are backed by actual market research and analysis. Furthermore, viewing others’ gains will often introduce an emotional bias in your investing decisions, which can influence these decisions, often to your detriment. If you choose to frequent /r/wallstreetbets, please do so with moderation and do your own research.
Here are a few of my favorite posts from /r/wallstreetbets:
You are a veteran investor, right? What are some of your positions and how much did you make on options?
- 55 PLTR shares @ 10.97 avg
- AMC 03/19/21 5c
- GME 01/15/21 25c
- PFE 12/11 40c
- PLTR 12/11 16.5c
- PLTR 12/18 17c
- PLTR 12/24 26c
- PLTR 12/24 40c
- PLTR 12/31 30c
- PLTR 01/15/21 20c
Sidenote: I am proud to say that I caught onto PLTR long before the Internet caught onto it. I initially invested in the company because of its unique business model and because I think it still has a lot of room to grow. The GME and PFE calls are betting on next-gen console sales and a potent vaccine, respectively, while the AMC calls are betting on a potential vaccination initiative in the United States (credit to Vlad).
Is there somewhere I can talk about investing with chill people?
Yes! I and other seasoned investors have set up shop in the Marianopolis Literature Club Discord server; we have a channel dedicated to investing and other related matters. We also have a homework help channel!