3 Ways To Make Money When Stocks Fall

How do people make money when stocks go down? Three primary ways to make money when stocks fall are via short selling, put options, and going long volatility.

Each of them has their own merits and risks as we will discuss below. 

Short Selling

Short selling is the process by which a trader borrowers money from their broker to sell a stock. The idea is to sell a stock at a higher price and buy it back at a lower price.

Conceptually, it’s not different to the more conventional approach of going long a stock which involves buying first and selling later. The difference is simply the the time order of those two actions is reversed, so traders sell first and buy back the stock later.

For new investors, that concept requires a bit of head-scratching at first because the obvious question is how can you sell what you don’t know and that’s where borrowing comes in. While you don’t yet own the stock, your broker has the stock in its inventory to lend to you now and which you can buy back in the future.

An overarching difference between buying stock and shorting stock is that the most you can lose when buying stock is what you pay for it but when you short stock, you can theoretically lose a lot more because you are on the hook for it as high as it goes.

For example, if you short stock at $20 per share with the aim of buying it back at $15 per share for a $5 profit, you could be left very surprised and substantially in the red if it instead rises from $20 to $30 per share, creating a $10 per share loss. 

Sometimes when stocks go up a lot, contrary to expectations, short sellers are forced to buy back their positions creating what is called a short squeeze.

In order to short stock, you will also need to set up a margin trading account because the broker is effectively lending you something and you need margin to be able to borrow it.

Another way to bet on stocks going lower without shorting stock is to buy an exchange-traded fund that profits when prices fall. For example, the SQQQ represents the ProShares UltraPro Short QQQ ETF and so is tethered to the inverse of direction of the QQQs, meaning as the NASDAQ falls, SQQQ rises.

Put Options

Buying put options is another well-known way to profit from the decline in prices of stocks or indices. Put options are essentially bets against the market, and so they should be used sparingly by all but the most skilled market timers given that the general trend of the market over time is up.

When markets do fall, however, the declines can be sharp and fast, which are precisely the conditions that cause put options to profit the most.

The reason for that originates from the way options are priced. In order to make money with options, a trader needs to be correct in both direction and time. That contrasts with buying stock where you simply need to get the direction right to profit. If the stock remains flat for a long time it doesn’t hurt you.

With options, though, a component of the pricing is theta, or time-decay, so when buying an option, even if the underlying stock stays flat, the option will lose money with all else being equal because theta erodes its value.

The reason steep and quick share price declines are so lucrative is because another component of the pricing model is implied volatility, and when it spikes as it tends to do during market plunges, put options rise in value from that alone.

Add in the price decline to the implied volatility hike and you end up with a highly profitable put option trade when stocks fall.

The way it works is if you have a stock trading at $100 per share and you buy a put option, which typically will have at least 3 months of time value to avoid the accelerated time-decay effects nearer to expiration, the put will gain in value if the share price quickly falls to $90 per share. In fact, if you bought it for $3 per share it would certainly be worth $10 per share or more at that time.

As you can see, the percentage gains when trading put options are potentially enormous. In this example, a 10% decline in share price results in a gain of over 200% in the option.

The reverse is also true, though, because if the stock went up and the long put option lost value it could lose a large percentage in a hurry also. A 5% gain in the share price could be sufficient to create a 50% loss or perhaps even more in the put option.

Buying Volatility

A final approach to making money when stocks fall is to go long volatility, meaning betting on volatility spiking when markets fall.

The benchmark indicator for volatility is the Volatility Index, and historically it has spiked when share prices fall precipitously. Indeed, the VIX rising above 50 has often corresponded to market lows forming soon afterwards.

So, extremes in the Volatility Index often coincide with major market turning points. This is more true when the VIX spikes than when it hits new lows. Often extreme lows do not correlate with market tops forming but extreme highs in the VIX do overlap with market bottoms.

While the VIX cannot be purchased directly, it is possible to purchase the VIX options, though we caution that approach is valid for only the most skilled traders because the options are not based on the VIX spot but VIX futures.

Instead, consider the VXX as a reasonable proxy for the Volatility Index. As volatility starts to rise in the market, VXX is likely to go up also and can act as a reasonable hedge against an equity portfolio, cushioning the blow from falling prices.

 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.