Are you looking for ways to hedge against or capitalize on stock market downturns? Perhaps you're looking to do a little of both—that is, to attempt to hedge your current shares of stock while opening new positions to seek profit off the downside of a falling stock market.
Whether you're looking to protect against or profit from a bearish turn, perhaps the most direct approach is to simply short stock or the market; that is, sell an asset at a higher price now, with the aim of buying back the same asset at a lower price later. It's still the same "buy low and sell high" principle that underlies all investment practices. You're just attempting to do it in reverse.
Three ways to short the market
There are many ways to play the upside of a downside market. Some trading strategies are relatively simple, while others can be quite complex. Some come with limited risks, while others may expose you to extreme risks and unlimited losses. For starters, here are three relatively straightforward ways to short the market using stocks, options, and futures.
Before we continue, note that in order to initiate a short position with any of these approaches, you'll need (respectively) a margin account for stock trading, an options account for which you're approved, or a futures account.
Short selling stocks
Risk: Unlimited potential losses because there is technically no limit to how far a stock can rise
Aim: To seek profit from share price declines
Here's a hypothetical scenario: Suppose a trader senses weakness in stock WXYZ; its overall fundamentals appear unhealthy, and its earnings capacity seems weak. The trader is anticipating a price decline, and they aim to generate a positive return when the price of the stock drops.
Stock WXYZ is trading at $50 per share, but the trader thinks it's worth much less than its current valuation. They decide to short 100 shares, a total net position of $5,000. Then WXYZ share price falls to $35 per share, and the trader "buys to cover" (i.e., buy back or repurchase) 100 shares at that price. Essentially, they bought 100 shares at a lower price (at $35) and sold them for a higher price (at $50), but they did it in reverse order. Their profit before commissions, fees, margin interest, or other payments, such as dividends (should they apply), would be $15 per share or $1,500 (15 x 100 shares).
Now, if the stock price of WXYZ had moved in the opposite direction by the same amount—if its stock price had risen instead of fallen—the trader would lose $1,500 (more if they consider the commissions, fees, and other applicable costs). So, before jumping in, especially for beginners, learn more about the basics of short selling stocks.
What about short selling stocks to hedge long positions?
What if a trader's aim isn't to profit from a stock's price decline but to attempt to preserve profits or mitigate losses on their current stock position? Can they place a direct hedge to protect their stocks? The answer is no; traders can't place a direct short position, or hedge, to match, stock by stock, their current long position.
Essentially, you can't be long and short on the same stock at the same time. However, in some cases, traders attempt to hedge their position by short selling a highly correlated stock, sector-based exchange-traded fund (ETF), or index fund, although correlations aren't always stable, and stock, sector, and index prices may diverge. This isn't a direct hedge, but in some cases, assuming continuing correlation, this trading strategy can be used to help protect some of your gains rather than liquidating your stock positions.
Buying put options
Risk: Limited to the premium paid if you hold a long position on an option (until the option expires)
Aim: To seek profit from share price declines
One way to potentially benefit from a stock's price decline would be to buy a put option, which gives the buyer the right, but not the obligation, to sell the stock at a predetermined price (the "strike" price) on or before a specific date (the expiration date of the option).
When it comes to gaining short-term exposure on a stock, in contrast to a straightforward short sale that exposes you to unlimited losses, the risk of buying a put is typically limited to the price—the "premium"—paid for it. If the option is out of the money—the market price of the stock is above the strike price—at expiration, the put option will expire worthless and 100% of the premium paid is lost.
If the stock price suddenly drops before expiration, the premium will likely increase in value and the put option could potentially be sold for a profit. Note, however, there is no guarantee that the premium will increase even if the stock price falls because other factors—such as time and volatility—affect options prices as well.
While purchasing a put may appear to be a relatively simple transaction, options contracts aren't simple instruments. There's a lot that goes into the mechanics of options trading and options pricing. Before you jump in, you'd want to review the fundamentals. For example, holding an options position until expiration can have unintended consequences. If the put option is in the money—the stock price is below the strike price—by even $0.01 at expiration, the put is subject to automatic exercise and the underlying stock will most likely be sold at the strike price, resulting in a short position (unless the put holder also owns the shares in their account). And, if your account doesn't have enough money to support the resulting short position of the borrowed stock, your brokerage may, at its discretion, choose not to exercise the option.
Although complex, once you become familiar with options trading mechanics, you may uncover new trading strategies for when you forecast a downtrend in the market.
Short selling futures indexes
Risk: Unlimited losses because there is technically no limit to an index or commodity's upside, or limited, if you hold the underlying instruments
Aim: To seek profit from a market decline or to hedge a portfolio of equities
Short selling futures involves some different rules. However, similar to selling stock short, you can sell (short trade) a futures contract to attempt to profit from an anticipated price decline of an index, commodity, or currency. Because futures include "equity" indexes like the S&P 500®, Dow Jones Industrial Average®, and Nasdaq-100®, you can also short index funds to hedge your equities positions, as long as the number of short futures contracts matches the size of the equities positions, and the index accurately reflects the exact composition and weighting of the stocks within the portfolio.
Bear in mind, futures trading is exceedingly risky and is not for every investor or trader. Futures are highly leveraged instruments, which means futures can be capital-efficient but also that it takes very little money to gain a lot of exposure…and things can move quickly. Profits and losses are amplified. And because you're trading in a margin account and using leverage that exceeds what's typically available for stocks, you're responsible for instruments where the total value can exceed the amount of capital in your account, which can trigger a margin call. If you're not careful, you can lose more money than you have. Keep in mind, margin with futures is much different than with stocks in many other ways as well.
Futures margin, also known as a "performance bond," is the amount of money you are required to deposit in your futures account to establish and maintain a futures position. Futures margin is not a loan. If at any given time the funds in your account drop below the minimum regulatory requirement, or "house" margin requirements, you may be required to immediately deposit additional funds to maintain your position, or your position may be liquidated at a loss. You will be liable for any resulting debits. Charles Schwab Futures and Forex LLC may increase its "house" margin requirements at any time and is not required to provide you with advance notice of such requirement changes or liquidations initiated by Schwab. You are not entitled to an extension of time on any type of margin call.
Bottom line on short selling
Markets run in cycles—sometimes up; sometimes down. The good news is that there are tools available to investors who choose to try to take advantage of, or protect themselves from, the market's downside. If you think short selling strategies may be right for you, it's important to understand the risks as well as the potential benefits.
