3 Ways to Profit from Falling Stock Prices

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Oct 14th, 2010 | By | Category: Featured, Investing Strategies, Macroeconomics, Options

It’s not surprising that most investors cringe at the thought of betting against the market – after all, the pundits on financial news channels work hard to tell investors that bad times are fleeting and good times are always just around the corner. Until recently, most investors were inclined to believe it.

Why wouldn’t they? It’s long been common knowledge that stocks average 10% annual returns in good times and bad; all you need to do is hold on through the bad times. That all changed during the bear market of 2008…

By the time panic subsided and the dust had cleared, major stock indexes like the S&P 500 and the Dow had finished down on the decade. Long only investors lost their shirts while bearish traders made a fortune by betting that stocks would continue to tumble. Even now, the idea of betting against the market (or, “shorting” the market, in Wall Street lingo) makes traditional investors anxious. But it doesn’t need to.

With the S&P 500 teetering toward “overbought” status, here’s a glimpse at three ways to profit from dropping stocks right now.

First and foremost, let’s get the terms down. When investors talk about their positions in a stock, they generally specify whether they’re “long” or “short”. Those words have nothing to do with the amount of time they’re holding their investments. Instead, they tell us about the direction they expect a specific stock to go. Long-side (bullish) investors are betting that their investments will see an increase in value, whereas short-side (bearish) investors expect valuations to drop.

Obviously, taking on a long position in a stock is fairly simple – you just buy shares. Taking on a short position is a little more complex, and comes with a new set of risks and rewards. With that in mind, let’s take a look at your options…

1. Short ETFs

Short-biased exchange traded funds (ETFs) have existed for a while now, but their popularity increased substantially in the wake of 2008. Simply put, these funds are pre-packaged baskets of investments that are already positioned as bets against the stock market. The beauty of these ETFs, though, is that you can buy and sell them just like stocks.

If you think that stocks are headed lower, you can simply buy shares of a fund like the ProShares Short S&P 500 ETF (NYSE: SH) and watch the fund rise each day the S&P drops.

For investors who want even more exposure to the short side of the market, there are also leveraged short ETFs like the ProShares UltraShort S&P 500 ETF (NYSE: SDS), which moves twice as much as the SH fund above.

The biggest drawback of short ETFs is the fact that these instruments paint with broad strokes. In other words, you can’t short specific stocks – instead, your options are relegated to major indexes or sectors that already have ETFs in place. Ultimately, short ETFs are an easily accessible option that investors can turn to for broad-bets that the market is headed lower. For more surgical trades – and higher gain potential – you’ll want to turn to other short strategies…

2. Short Selling

Short selling is perhaps the most well known way to bet against stocks. With short selling, you’re able to bet against specific stocks, not just industries or sectors. As a result, it’s possible to develop lucrative trading strategies by shorting especially volatile stocks on the way down.

While most investors have heard of short selling at one time or another, not all know how it works.

Let’s say that you wanted to short 100 shares of Bank of America (NYSE: BAC) last month when the stock was trading at $13.68. To do that, you would have gone to your broker and borrowed those 100 shares, then sold them on the market for proceeds of $1,368. The money would sit in your brokerage account until you were ready to “cover” your short, and close out the position. To cover, you’d just buy another 100 shares of Bank of America – now trading 8.5% lower at $12.52. That would cost you $1,252.

The difference between those two numbers – $116 – would be your profit…

Not surprisingly, there are risks to shorting stocks. The biggest risk is what could happen if you’re wrong. Unlike long-side investing, where you can only lose your initial investment, shorting exposes you to hypothetically unlimited risk as share prices rise on the stock you’re betting against. Had shares of Bank of America risen to $15, you’d be sitting on losses of $132. If the firm discovered a secret gold mine under its corporate headquarters and shares jumped to $100, you’d be out $8,632.

There are also other downsides to shorting (like margin calls and interest charges) that we won’t touch on today.

Because of the complexity of selling stocks short, this isn’t a bearish strategy that I’d recommend for newcomers to the investing world.

3. Options

The final short-side strategy we’ll touch on today is options. Like short selling, options are a tool that I’d recommend new investors stay away from. For those who understand the risks at hand, however, options can be one of the most profitable ways to take on a bearish trade.

Options are derivatives – that means that their value is based on something else. But don’t let the word derivative scare you… Essentially, an option is a contract to buy (call option) or sell (put option) a stock at a specified price. To bet against the market, the simplest way is by buying put options, which allow you to sell shares of a stock higher than a predetermined price (strike price).

Because smaller movements in share prices can move an option above and below its strike price, options offer investors amplified gains. Those amplified gains come with one big caveat: options carry an expiration date, which means that their value is directly impacted by time. The biggest benefit to options is that investors can bet against individual stocks while still maintaining finite risk – unlike short selling a stock, buying put options only risks your initial investment.

While betting against the market may seem anti-intuitive to buy-and-hold investors, it could be the only move that can save your portfolio during a bear raid. That’s not to say that you should just dive head-first into placing short-side bets… If you’re new to the three strategies I described, I strongly recommend that you paper trade to avoid putting real cash behind rookie mistakes.

Jonas Elmerraji
Managing Editor, Penny Sleuth

October 14, 2010

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Jonas Elmerraji

Jonas Elmerraji, CMT, is the co-editor of STORM Signals and Penny Stock Fortunes, and a contributor to Agora Financial’s Trend Playbook. Jonas got his start on the fundamental side of the market, poring over financial statements and valuations to find sound investments – today, he specializes in blending fundamental and technical analysis. Jonas is a senior contributor to TheStreet.com, and has been featured as an investment expert in Forbes, Investors Business Daily, and CNBC.com among others. 

Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

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