There are lots of ways to make money from a falling stock market, some speculative, and some not so risky. It’s great that these options are available, because small investors need a way to protect themselves, and even make money on the downside. Many traders and investors believe that the stock market has reached a peak. Here are several options to choose from.
1. Shorting Stocks
OK, let’s get this one over with first because it is one of the most speculative and risky ways of making money in a bear market. In simple terms, you make money when the stock goes down and you lose money when the stock goes up. What technically happens is that you borrow the shares and immediately sell them (this all is done electronically through your brokerage firm) and since you owe those shares, you eventually have to buy them back at some price, hopefully a lower price. The difference between your sale price and eventual purchase price is your profit.
Can you make a lot of money shorting stocks in a bear market? Yes. Is it speculative? Very. Can you lose a lot? Most definitely. This is why it is so risky. When you short a stock, the lowest point it can drop to is zero. Whereas, if the stock goes up, the amount it can increase is unlimited. Let’s say you short 100 shares of a stock at $20 a share. If you put up funds equal to 100% of the value of the shorted amount, and the stock drops to zero, you’ve made a 100% return. However, suppose the stock goes from 20 to 100, you end up losing 400% of your money with lots of margin calls along the way.
Have I shorted stocks? Yes. Have I made money from shorting? Yes. Have I lost a big chunk of my profits by closing out my short positions and going long, trying to predict the bottom? In the interest of full disclosure, yes. Several years ago, I made the second worse decision I could have made when shorting, and that is predicting the bottom of the market too soon. The worst decision would have been to hold on to my short positions after the market bottomed and started to make a quick rise. Often when the market bottoms at the end of a bear market, the rise is very sharp and fast, and can totally wipe out short position profits very quickly and then some.
Just before the big crash several years ago, shortly after I shorted a high priced stock selling for about $100 a share, the position went against me by 13 points. That’s a $1,300 loss for just one hundred shares in one day! I still had the short position after the market closed, and had the pleasure of trying to sleep at night, wondering if there was going to be a takeover the next morning or some other good news that would drive the price even higher, making my losses worse. Fortunately, the stock crashed along with the rest of the stock market and I ended up making a profit, but it was very stressful waiting for it to happen.
One way to hedge yourself is buy buying a call option on the stock you sorted, to protect yourself in the event the stock rises.
So in summery, do I think you should short stocks? Absolutely not. The risk is unbelievable. If you understand options real well, hedged short selling might be OK, as long as you are an experienced trader, and know what you’re doing.
2. Short (Bearish) ETFs
There is a type of Exchange Traded Fund called the Bearish ETF or Short ETF. What these ETFs do is provide a return opposite to the return of the index, sector, or industry that it is tracking.
For example, the Short Dow30 ProShares (DOG) provides a return that is the inverse of the Dow Jones Industrial Average. If the Dow goes down 2%, the DOG goes up 2%. The Short QQQ ProShares (PSQ) ETF gives a return that is the inverse of the NASDAQ 100 Index. If you are bearish on gold, you can buy the PowerShares DB Gold Short ETN (BGZ) ETF.
The nice thing about these short ETFs is that your losses are limited. Also, if you are long individual stocks that you don’t want to sell, these can be good for protecting your portfolio on the downside.
3. Leveraged Bearish ETFs
If you like volatility, you will love the leveraged bearish ETFs. What these ETFs do is provide double, and in some cases triple the inverse return of indices. One example is the UltraShort Telecommunications ProShares (TLL), the Rydex Inverse 2x S&P Select Sector Health (RHO), the UltraShort Consumer Services ProShares (SCC) and the Rydex Inverse 2x S&P Select Sector Tech (RTW).
In addition there are over a dozen triple leveraged bearish ETFs. Talk about price moves! The volatility of these things is unbelievable, and so are the wide bid and asked spreads that I’ve seen occasionally.
The advantage of these trading vehicles is that they are a way of shorting on margin, with a limit on the downside. The disadvantage is that the losses are quick and large, especially with the triple leverage short ETFs.
4. Bear Funds
It may be hard to believe, but there are actually a large number of bearish mutual funds for the long term bearish investors.
There are many bearish mutual funds, including the Grizzly Short Fund (GRZZX), the PIMCO StocksPlus TR Short Strategy Institutional Fund (PSTIX), and the ProFunds Bear Investors Fund (BRPIX). These funds have minimum investments ranging from $1,000 to $5,000,000.
I’m not sure why anyone would invest in these unless it is for some kind of a long term hedge.
A put is the option to put your stock to someone at a particular price within a certain period of time. In other words, if you own a stock that is trading at 22 and you buy a put at a dollar [puts and calls are priced on a per share basis, so a put at $1 would cost $100 for 100 shares] which gives you the right to put your stock to someone at $20 per share within three months, there are a couple of things that could happen. The stock could tank to $14 a share and you could put your stock at 20, or just resell the put for 6. You would be far better off than just doing nothing. And if the stock goes up or stays about the same, you are just out your $100 for the option. Puts can be useful for experienced traders.
There is one other way to make money in a bear market. Sell everything, and keep your money in cash, preferably a T-bill money market fund, that only owns T-bills. (Repos are supposed to be just as safe, but these days, I would look for the ones that just own the T-bills. I will cover repos in another article.) The advantages are that you can’t lose money and you can receive an income from the investment.
Hopefully, this post will provide you with some ideas to hedge your portfolio in the event the stock market does tank, and maybe even make money from the market drop.