Bears, or those who expect the stock market to decline in price, generally make money by selling stocks short. But that is not the only thing you can do. If you’re a conservative investor, the best way to make money when stocks fall is to save up a cash reserve and add to your holdings when the prices are low. If you’re a trader who is willing to take substantial risks, there are some option strategies that you can use. You can also buy inverse ETFs. We’ll talk about all of these options in this article.
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In the process of short selling, a speculator first selects a stock to sell short, often based on an analysis showing that the stock is overpriced, on stock charting patters that show a top in stock price, or because of expectations about future company prospects. The speculator then puts in an order to sell the stock short to his broker.
The broker finds a client who 1) has a margin account with the brokerage, 2) is currently in margin and 3) who owns shares of the stock the speculator wants to sell short. The broker borrows the shares from the client, often without the knowledge of the client, and sells them on the market for the speculator. (As an aside the IRS looked at charging capital gains taxes to the individual whose shares were borrowed without his knowledge – glad that didn’t pass.) The funds from the sale are then deposited in the speculator’s account. During the time that the shares are sold short the speculator will need to pay any dividends the stock pays to the individual from which the shares were borrowed.
If the bearish speculator is right about the stock, it will decrease in price. He can then buy back the shares on the market, giving them to the broker who will return the shares to the client from which they were borrowed. The closing transaction is called “covering” the short sale. Because he bought the shares for a lower price than he sold them for he will have made money. It is like buying and selling a stock, but in reverse.
Selling short is a fairly dangerous strategy in that there is no limit to the amount of money you could lose. If you buy 100 shares of a stock for $10 per share, the most you could lose is $1000. If you short 100 shares of a stock at $10 and it goes to $100 per share, you’ll have lost $9000. If it keeps going up, you’ll keep losing money. If you do choose to sell stocks short 1) have ample cash in your account to avoid a margin call, 2) keep your positions a lot smaller than what you are willing to lose and 3) keep an eye on your positions and be ready to cover and close out if things go against you. And never, ever, average up by shorting more if the stock moves up in price. That’s a great way to lose a lot of money.
One of the best things to do in a falling market, assuming that you still have many more years before you’ll need the money, is to ramp up your buying when shares fall. This works well when everything is falling and is actually a very conservative strategy since stocks will go higher eventually if you have enough time to wait it out. You can easily buy shares for 30%, 50%, or even 90% lower when there is a significant market decline. If the stocks go back up where they were after the fall as they will in a “V-shaped recovery,” you will have made a good profit. Even if they don’t recover all of the way for a while, you’ll get a little bit of a bounce that will put you in a better place than you would have been if you had just sat firm with your potions. As the saying goes, “Be greedy when others are fearful, be fearful when others are greedy.”
Even in extreme cases like the Great Depression, if you had bought right before the crash and just sat firm, it would have taken you 15 years to get back to even. If you had bought shares regularly after the crash and kept buying, you would get back to even far sooner and actually have a nice profit after the 15 year period. Note that trying to swoop in during a market fall and buy shares, trying to buy at a bottom, is called catching a falling knife and is very difficult to do. Instead, expect to buy some shares initially before a bottom and then buy more shares as prices continue to fall. Buying shares with a fixed number of dollars regularly is always a good strategy since you’ll buy more shares when prices are low and less when prices are high, causing you to make money even when the markets are flat. This is called dollar cost averaging.
Buying individual stocks when they fall is a different matter. While you can sometimes pick up shares cheap and make a good profit when shares fall quickly, there is usually a good reason that a stock falls in price when the rest of the market sector is not falling. Wait a while and see if there is a slow down in business for the company or even a scandal before you buy more. If everything seems good, then you can add to your position. If there is a reason for the decline, however, it is best to sell what you have and move on. Individual stocks can take years to recover, often lag the rest of the market as they recover when they fall by themselves, and can even disappear if the company goes bankrupt.
Going short by using options
An alternative to doing a short sale is to buy put options. These are legal contracts that allow you to sell a certain number of shares at a certain price before a certain date. If the stock goes down quickly, the price of the contract goes up and you can sell the contract and make a profit. If the stock doesn’t go down quickly enough, the price of the contract will decline with time until it becomes worthless on the expiration date. These is a market that sells standard contracts, making it easier to do than it would otherwise. You need to get approval from your brokerage firm to trade options. Once you do, it is as simple as entering a stock trade.
While the process is simple, it takes some studying to learn how options work and you should do some reading before you try it. Some books on the subject include Trading Options For Dummies (For Dummies (Business & Personal Finance)) and The Options Edge + Free Trial: An Intuitive Approach to Generating Consistent Profits for the Novice to the Experienced Practitioner (Wiley Trading). Take your time learning about the rules, how to know when options expire, how they behave over time, and how you can make or lose money using them. You may also want to try some “paper trades” where you pretend to buy a position and watch to see where you would make money and where you could lose money.
Trading options, particularly in strategies like spreads and straddles where you buy both put and call options (see below), can also result in strange reports in your brokerage. recently there was a college student who committed suicide when he thought that he had lost hundreds of thousands of dollars because of the way things were reported in his online profile during the days after a position he had expired. In actuality, he probably only lost a few thousand dollars and it would have shown that in his statement if he had waited a day or two. Be aware of this and don’t freak out if things look strange sometimes. In fact, trading options this way is not something many people should do.
One nice thing about buying put options is that your loss is limited to the amount you pay for the options. The bad thing is that they expire within a limited time window. You must therefore both be right on the direction of the stock or market and the timing. This makes your chances of making money a little less than with short selling since you can’t just wait around for the fall. It needs to fall fast or you’ll lose money.
There are also options contracts called call options that act in exactly the opposite way as put options do. They give you the right to buy a stock at a certain price before a certain date. You can make money if the markets decline by selling call options short, which is called writing call options. A fairly conservative way to do this is to write a call option against shares that you own, such that if the stock goes up, the person who you sold the call option to gets your shares. Your loss is therefore limited. (Actually, if the shares go up a lot you will make a profit, but your profit is limited.) A very dangerous method is called naked call writing, where you write call options without owning the shares. In this case, if the stock goes up you will need to go out and buy the shares to fill the order. Because you’ll only get paid like $500 on a set of 1000 shares of stock at $20 per share, you could end up owing $10,000 or $20,000 if the stock jumps $10 or $20 per share, while your profit is limited to $500. Not a good ratio!
Finally, there are index funds called Inverse ETFs that allow a speculator to profit when the markets fall. These are like highly speculative mutual funds that short a sector of the market for the investor. For example, you can buy an ETF that shorts the S&P500 index. If the S&P500 goes down $1000, the ETF will go up $1000 in price. Obviously the same holds true in reverse when the S&P500 goes up.
There are also ETFs that are like inverse ETFs on steroids. They will go opposite the index by 200% or even 400%. So, if the S&P500 goes down $1000 in a day, the ETF would go up $2000 or $4000. There is a big danger with these funds, however. The issue is that the fund changes value daily with the change in the fund’s price matching twice or four times the change in the index price each day. With the odd way that the math works, if the stock goes up and down, rather than going straight down, you’ll lose more on the days when the index goes up than you’ll make when the index goes down. This means that you can lose money even when the index stays fixed in price if it bounces up and down, drawing lines. You can even lose money when the index goes down if it bobs up and down enough on the way down. These types of ETFs should therefore be avoided unless you really expect a fast and consistent downturn. They should not be held for long periods of time since you’re almost guaranteed to lose money that way.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing