When the stock market teeters on the brink of bear season, it might feel like your options for making money from share price appreciation alone are severely limited.
However, there are still plenty of ways to profit when market prices are falling. Here are some of the most popular ways to bet on a stock going down, and the risks attached with them.
Selling Short Stock
One of the most common ways to benefit from a falling share price is to use what is known as short selling.
Short selling is a strategy that investors use when they believe the market will continue in a bearish trend, and the process involves an investor borrowing a security that does not belong to them, and selling that asset on to the market at a given price.
The seller then hopes to buy the security back at a later date, when the value of the security has fallen, after which they can then return it to the original owner.
Risks of Short Stock Selling
Although shorting stock appears like a pretty simply endeavor on the face of it, in reality the mechanism is fraught with danger.
In theory, the losses you risk with going short are actually limitless, and, because stocks can fall at a much faster rate than they appreciate, many inexperienced investors can stand to lose large amounts of money in a very short space of time.
For example, when an investor buys a share in, say, Microsoft, the most that investor can lose is $304 – or whatever the price of the share is at the current time of purchase. The lowest the stock can fall to is $0, and therefore the magnitude of the potential loss is limited.
However, if the same investor were to short MSFT instead, the scale of their losses would be theoretically infinite, because the price of a stock can go on rising forever.
In the example of shorting Microsoft stock, if the share price had risen to $400 before the investor had closed out their position, they would have lost $96 per share. If the price continued upwards without stopping, the investor would be looking at potentially unlimited downside.
Short Stock Squeeze
In addition to the very real risks of going short on a stock, there is also a particularly nasty trap that can ensnare investors known as a “short squeeze”.
A short squeeze happens when short interest in a stock is high – i.e. when a stock has been sold short in high volumes – and the price of the stock suddenly begins to climb higher in price. This acts as a catalyst for other short sellers to exit their positions by buying back the stock, which in turn drives the price higher.
Regardless of whether a short squeeze occurs, investors have to monitor their margin account constantly to ensure it is adequately funded with sufficient capital to keep their short position open.
Even temporary price spikes which don’t lead to the full cascade event of a short squeeze can force investors into putting extra funds into their trading account, preventing their broker from abruptly closing their shorts and leaving them holding a loss on the trade.
Costs of Shorting Stock
There can be fairly high costs associated with shorting stock, with the usual trading commissions and fees just the start of it.
For instance, stocks which are already heavily shorted – or have a limited share float – will incur high borrowing costs, and the trader will be obligated to pay a “hard-to-borrow” expense for the opportunity to short those specific securities.
Furthermore, there is interest to be paid on the investor’s margin account too, and, perhaps surprisingly, short sellers are also expected to pay any dividends due on the shares, as well as any other payments attached to the asset, including divestitures and stock splits.
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Put Options
Buying put options is another strategy that bearish investors can use when the market is going down.
Similar to shorting stock, put options are a way to capitalize on falling share prices, but with much less exposure to the kinds of risk that going short entails.
When an investor buys a put option, they acquire the right, but not the obligation, to sell an underlying security at a stated price and within a given time frame. The price at which the owner of the put contract is entitled to sell is called the “strike price”.
Why Buy Put Options?
Put options are especially good for hedging against a decline in an asset’s price, because the maximum an investor can lose is the price they paid for the contract – otherwise known as the put premium.
Investors also don’t have to hold a margin account to buy puts, making them an attractive option for those with limited capital.
In contrast to the protective put used to hedge against an existing portfolio, speculators can also use long puts to profit from markets losing value over time.
Risks Of Buying Puts
The risk profile of buying puts is more favorable than going short on a stock, although there is still some downside associated with put options.
For investors using puts to hedge a position, their hope is that the asset will still move up in price, but the protective put they have in place can be used to mitigate losses if that scenario doesn’t play out. The risk they undertake is limited to the price of the put premium, as well as any commissions paid to the broker.
For speculators, however, their hope is that the market will go down. In this example, the risk is the same as for hedgers – the maximum loss is still the premium price – but the amount of profit that can be realized will depend on the cost of the premium, and the decision of when they want to sell.
Many speculators will have a target price in mind, and will sell the put when that target is reached. However, the price movement in a security can change, which can wipe out any unrealized gains if the contract isn’t already sold.
Inverse ETFs
Another way to make money when share prices are on their way down is through the use of inverse ETFs.
An inverse ETF – or a short ETF, as they are sometimes known – is an exchange-traded fund (ETF) designed to deliver the inverse performance of its underlying asset or benchmark. In practice, an inverse ETF is normally employed to return gains when a stock price falls, and are thus generally composed of derivatives that use short selling and other leveraged instruments.
One major benefit of inverse ETFs is that the investor doesn’t actually need to sell anything short themselves. Instead, all they need to do is purchase a stake in the fund in much the same way they would with any other normal ETF, and leave the rest up to the fund managers themselves.
The investor doesn’t need to have a margin account in which their broker lends them the money with which to trade, and the stock loan fee required for short selling doesn’t have to be paid either.
However, because inverse ETFs are a little more complicated to administer than regular exchange-traded funds, there is an additional expense when it comes to fees – but this is almost always less than it would be to sell the shares short instead.
The main drawback to using inverse ETFs is that, because the derivative contracts that the funds are based on are bought and sold everyday, they are not a good option as a long-term investment.
In fact, there’s no guarantee that the performance of the inverse ETF will match that of the index it is meant to track, and, due to the increased frequency of trades, fees and commissions can quickly add up.
Inverse ETFs can be found for most of the major market indices, and are an excellent way for investors to hedge their own portfolio.
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