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The stock market's strong upward bias has been the greatest generator of wealth ever known. But that doesn't mean you don't see bad stocks tumbling or downturns sinking indexes into the red.
Fortunately, these are opportunities to make money just the same as when stocks are charging higher. It just takes a different strategy to unlock these profits.
We're going to walk you through two of the most common ways to make money when stocks go down: shorting stocks and buying put options.
When you sell stocks short, you're borrowing shares from someone else, selling them for market price, and then buying them back at a later price to return them to the owner. If the stock drops, you'll profit on the difference between what you sold them for and what you bought them back for.
Put options give you the right, but not the obligation, to sell shares of the underlying stock at a fixed price by a fixed date. If the underlying stock falls in value, you get to sell it at the higher fixed price, netting the difference.
You can use both strategies to target weak stocks destined to fall, or you can use them like insurance against a correction or crash. But there are pros and cons for both strategies.
Let's take a look...
Pros of Short Selling
Selling stocks short, or shorting, lets you make money on a falling stock.
Instead of buying shares or options, you're borrowing shares to sell, pocketing the cash, and then buying them back later.
If the stock falls in price, you buy it back - called covering your short - and keep the difference between your sale price and purchase price.
Traders sell stocks short to profit from mispricing in the markets. Sometimes stocks can balloon in value thanks to frenzied buyers or fads that have nothing to do with the fundamentals of the company. When a stock is trading at unsustainable multiples of the company's actual earnings growth, savvy traders can use short selling to profit on its fall back to earth.
The main advantage of shorting stocks is that there is no time limit. Unlike options, which have an expiration date and time decay, you can hold your short position for an hour, a day, or even months before you need cover. However, different brokerages may have different requirements.
This gives the trade time to work without the risk.
Cons of Short Selling
There are bigger risks of shorting stocks than simply buying stocks, so it's not for everyone.
The main risk with shorting stocks is if the stock continues to climb higher, your losses could be infinite. With buying stocks, your risk is limited to the amount you paid to buy the shares. With selling short, your risk is theoretically unlimited. Since you've sold borrowed shares and need to buy them back to pay the debt and there is no limit on how high a stock's share price can go, you could be on the hook for massive losses. This sort of risk is not for everyone.
That's also why your broker may require a certain account size, trading activity, or a signed disclosure of your suitability to short stocks, making short selling hard to get into in the first place.
Another con is that lots of short selling can work against you too. A heavily shorted stock could be a sign that many investors see the stock the same way you do. But it could also create buying pressure that pushes shares higher.
Here's how that works. Since short sellers lose money when share prices rise and their potential losses are theoretically unlimited, they have a big reason to abandon the trade and buy back shares if the stock starts to rise. When a stock is heavily shorted, a bump higher in the stock price can force those short sellers to scramble to buy back shares to limit their losses. That buying pushes up prices even higher. It becomes a positive feedback loop that could compound your losses.
This is why short selling is not for everyone.
Pros of Buying Put Options
Buying a put option gives you the right to sell a stock at a specific price by a specific date, so you profit if the share price of the stock drops below the strike price of the option.
There are four big advantages to trading put options if you want to profit when stocks go down.
First, buying puts lets you profit from a stock price drop without the limitless risk of short selling. You only risk the amount you paid to buy the options contract.
Second, options trade for a fraction of the price it costs to own the stock, which lowers your risk. Your up-front costs are lower than if you shorted the stock. That also reduces your risk since you aren't tying up all your money on one trade.
Third, this leverage helps you make more money. A small percentage change in the stock price can translate into a much larger percentage gain in the options contract's value, since each contract controls 100 shares of the stock.
Since options contracts are bought and sold on the market, the more demand there is for your contracts, the higher the price you can fetch. You don't have to exercise the contract to sell the stock at the higher price.
Lastly, you can tailor a strategy with put options to the specific situation.
If you want to hedge against an overall drop in the market, you can buy long-dated puts on broad market ETFs. If you're expecting a specific stock to drop, you can buy puts on it.
You can dial in this strategy even more depending on if you're expecting a small move lower, a large move lower, and even no move lower at all.
For example, if you think a stock is going to fall modestly, you can buy a put with a strike price near the stock price and then sell a put with the same expiration date but with a lower strike price. Your potential profits are capped, but your starting costs, and hence risk, can be much lower.
Cons of Buying Put Options
There are three main cons to put options.
First, while options can be used to lower your risks, they aren't without risk. Since options have an expiration date, there's a risk yours can expire worthless, meaning you lose all of your initial investment. The expiration date also creates time decay, meaning your contract will lose value as the expiration date gets closer unless the stock falls quickly enough.
Second, many brokers will require that you sign an additional agreement certifying that you understand the risks and have the experience to trade options. This is typically a smooth process, but it's possible to be denied options trading approval, especially if you indicate you are risk averse.
Third, finding the right option to buy can be tricky.
You will have a wide array of strike prices and expiration dates from which to choose. Some are lower in price while others will become profitable sooner. Not only that, but option pricing depends on several factors, including the underlying stock's volatility, time to expiration, the underling stock's current price, and even interest rates. We generally favor options that expire in about three to four months and are "near the money," with strike prices close to the underlying stock's price. But there are uses for many different combinations, so it helps to have an expert in your corner, at least at first.
Is Short Selling or Put Buying Better?
While we've laid out the pros and cons above, you might be looking for a simple answer.
There are pros and cons to both strategies for making money when stocks go down, but buying put options is likely the best play for most individual traders and investors. Risk is controlled, and you will enjoy the benefit of leverage to multiply profits if you are correct in your call.
And if you're looking to take your options trading to the next level, then you're in the right place.