We live in uncertain times. After seven years, the bull market is limping along, set to collapse under its own weight.
But before it does, you'd be wise to take some precautions — set yourself up to profit, even.
One way to do that is through the time-honored practice of shorting.
And that's exactly what I'm going to show you how to do.
Before we get to that, though, I want to talk about something else: risk.
The truth is, a lot of people are scared away from shorting because of the risk. And that's understandable. There is a certain amount of nuance that comes with shorting stocks. It takes confidence, patience, and resolve. The risk is real and definite.
But as you know, investing any money at all, in any asset — be it stocks, commodities, or bonds — carries risk. There is no such thing as a risk-free investment.
With shorting, especially using options, the oft-mentioned risk is your losses can theoretically be “infinite.”
That is, theoretically, the market could keep going higher and higher and higher, thus exacerbating your loss.
Still, we all know that the market doesn't go up in a straight line, without ever coming down. That's why we're shorting it to begin with. We're betting that there's more value to lose than there is to gain.
Furthermore, you can always get out of a short position. All you have to do is cover it. It may mean taking a loss, but it won't mean sitting helplessly by, watching your loss grow on into infinitum.
To put it simply, you don't have to be scared of shorting, you just have to be careful.
That said, here are three ways to short the market...
Keeping Your Options Open
Now, what do we talk about when we talk about short-selling?
In its simplest form, shorting means borrowing shares from your broker, selling them immediately, and them buying them back (closing) at a cheaper price. You keep the difference.
This process is fairly simple:
- You set up a margin account with your broker.
- You place your order.
- Your broker borrows the shares.
- Your broker sells the shares and gives you the money.
- You buy back the shares at later date, when prices have dropped.
In most cases, how long you stay in a short position is up to you. Traders may enter and exit a short sale on the same day, or they might remain in the position for several days or weeks, depending on the strategy and how the security is performing.
The key is obvious: MAKE SURE YOU HAVE ENOUGH MONEY TO BUY THE SHARES BACK.
Have a stop-loss number in mind, based on how much you invest. If you bet $1,000 against the market or a stock, have $2,000 ready in case it goes up. If the investment looks like it's going to double, cover it, and take your loss. Also, bear in mind that you're responsible for paying any dividends accrued during the period in which you hold the short position.
Aside from that, you're not obliged to buy the shares back until you're good and ready — though some brokers may have their own rules or time limits. Generally speaking though, you can keep your options open as long as you're nowhere near your stop-loss.
That's short selling, and you can do it with pretty much any stock, including the SPDR S&P 500 (NYSE: SPY) index fund.
You might also choose to target a company you believe is especially weak. Oil producers, for instance are struggling with low crude prices. Many of those are ripe for the picking. Retailers could also find themselves in a pinch if the stock market drop creeps into consumer confidence. Those are sectors I'd play particularly close attention to.
Now, let's talk about put options.
Put It This Way
Buying a put option gives you the right (though not the obligation) to sell a given stock at a certain price by a certain time. For that privilege, you pay a premium to the seller ("writer") of the put, who assumes the downside risk, and is obligated to buy the stock from you at the predetermined price.
For example, let’s say you’re bearish on a stock that’s currently trading at $70. You could buy a 70-strike put with no special rules or margin considerations to worry about. If the stock drops below $70 as you predicted, let’s say to $60, you buy the stock in the marketplace and then exercise your put. That's exercising your right to sell, and it gives you a profit of $10 per share.
You could also sell the put option contract in the market, as it will be trading at a higher price than what you paid to purchase it.
And if the stock rises?
If the stock rises, or doesn't drop, you could lose the entire value of the put option. But unlike short-selling, that’s all you can lose. In this case, your risk is capped.
Furthermore, you could still sell your put, but this time for less than you paid for it. That way you take a loss, but you still salvage some of your money before it expires worthless.
So this is a much less aggressive way of shorting.
Hedge with an Inverse ETF
Finally, there are exchange-traded funds. These are the simplest, and most conservative way to short the market.
You see, there are many ETFs that trade inversely to the market. That is, they go up when the market goes down, and they go down when the market goes up.
There are plenty to choose from:
- Rydex Inverse S&P 500 Strategy Fund (RYURX): One of the more traditional bear funds, RYURX delivers a return opposite to what the S&P 500 does. So if the S&P 500 goes down 5%, it goes up 5%. It's up 6% over the past month, compared to an 8% loss for the S&P 500.
- ProShares UltraShort S&P 500 (SDS): This fund is leveraged to give you twice the return of any drop in the S&P 500. For example, if the S&P 500 loses 5%, this fund goes up 10%. Be warned though, if the market goes up 5% this fund goes down 10%. SDS has returned 15% over the past month.
- ProShares UltraShort Russell 2000 (SRTY): This is a more aggressive play. Small caps are more vulnerable to sell-offs, and this fund targets the sector by delivering a return that is three times larger than any decline in the Russell 2000 index. This fund has surged 21.5% over the past month.
You can also short specific sectors. For instance, the DB Crude Oil Short ETN (NYSE: SZO) trades inversely to oil.
Again, the thing to remember about these funds is that they'll lose value so long as the market keeps going up. But the potential rewards can be great if the market suffers a setback.
At the very least they serve as a hedge. Maybe you stop out of your stocks and take a profit as the market goes down. But you let your inverse fund ride, and keep accumulating gains until we hit bottom.
Used appropriately, even a small allocation of your capital could more than make up for any losses you sustain in a market crash.
So that's shorting. It's not so scary or so complicated as it sounds. You might start out with a tiny bit of money just to get a feel for the process a few times. But as you build confidence shorting will become an indispensable part of your investment strategy.
-Outsider Club Research Team