Ways to Profit from Declining Stocks

Ways to Profit

The market can vary significantly from one year to the next. No one knows how far the market will decline. It may be just a small correction, but emotions and fear will take over, causing bad decisions to proliferate. Unless you have a plan, you are a ship without a sail. Here are some tips for staying focused and avoiding panic-driven decisions.

The stock market is sometimes compared to the tide. All ships rise and fall with the tide. Most stocks go up in a bull market, and most decline in a bear market.

Investors buy stocks hoping their stocks will increase in value. They get out when they see their stocks decline. This strategy takes advantage of the upside bias in the stock market. The average annual return of the S&P 500 over the past 50 years (1971-2020) has been 10.9%.

Instead of riding out a bear market, there are ways to make money when the individual stocks decline or the stock market crashes. This type of investing is riskier but can keep your portfolio growing or, at least, holding steady instead of dissolving. Here are a few ways to make money or protect your portfolio when some of your stocks start declining or during a bear market slide.

Sell Short

Let’s say you feel a stock will decline and you want to make money on the decline or protect a stock you own without selling it.  Selling short may be a good choice for you. Shorting a stock involves borrowing shares of stock you don’t own and selling them. If the stock declines, you buy the stocks at now lower price and give them back to the person you borrowed them from to make a profit. For example, you borrow Stock A and sell them at $60, the price declines, and you repurchase them at $50. Like any stock transaction, you subtract the buy price ($50) from the selling price ($60), making a $10 profit. If you are wrong, and the stock rises to $70then you lose $10.

However, there are some other situations in which shorting a stock can be useful. If you own stock in a particular industry but want to hedge against an industrywide risk, then shorting an ETF in the same industry could help protect against losses. Shorting a stock can be better than selling it from a tax perspective. You may be able to cover your stock with a short sale so that you can hold it for the next tax year. The stock This applies if you suspect the downward movement is temporary, and the stock will reverse itself and begin advancing.

To sell short, you must have a margin account with sufficient cash and your broker’s approval to open a short position. The biggest risk in selling short is that your shorted stock may rise dramatically in price. If this happens, you may find it difficult to cover your losses. Theoretically, when selling short, there is no limit to your losses. There is no limit to how high a stock price can climb.

Extra Expenses Charged to the Short Seller

There are hidden expenses that a short seller has to take into account. These must be included when calculating and profits or losses from the transaction.

1. Since you sold the shares already, the buyer you sold the stocks to receives any dividends paid. The person you borrowed the stocks from is entitled to receive the dividends. The short seller must pay this person any dividends paid while the shares are borrowed.

2. Some stocks that are hard to borrow require a stock borrow fee. This fee is paid by the short seller monthly and may change at any time.

Reasons Your Short Position May Be Closed without Your Consent

1. If you begin losing too much money, your broker may make a margin call. A margin call forces you to close your short position, thereby limiting any further loss to the account.

2. If there is an insufficient number of securities available to be lent, your short positions be closed without notice.

3. You may be forced to close your short position unexpectedly if the shareholder lending the stock to the short seller wants those shares back. In this case, your broker will force you to repurchase the shares, whether you want to or not.

Be Careful with Short Selling

Short selling can be a way to make money when a stock drops in value, but it comes with big risks and should be attempted only by experienced investors. Even then, the risks involved are significant.

By Puts

People buy puts for the same reasons they sell short. If you feel a bear market on the horizon or certain stocks are overvalued, you may see an opportunity to make money on the decline.

A put is an option that represents the to sell 100 shares of stock at a predetermined price. The put option has an expiration date, after which the option expires worthless. It also has a strike price, which is the specified price for selling the underlying stock. If your underlying stock or ETF declines, your put will gain in value.

Because options increase or decrease by a much larger percentage than stocks, even a small number of put contracts can offset your long stock position losses. As expiration is approaching, you have the option to sell your put on the open market or sell the shares.

Sell Naked Puts

Selling a naked put involves selling the put to a buyer for what is called a premium. If a put expires at or above the strike price, the put becomes worthless. The seller keeps the premium. On the other hand, if the stock price falls below the strike price and the holder of the put exercises the option, the seller is forced to take delivery of the shares at a loss.

It is best to sell puts on companies you would not mind owning if you had to take delivery. Even in a bear market, there are periods where a stock’s price will rise, making it profitable to sell puts. The biggest danger from selling puts is when stock prices crash through your put’s strike prices.  If the market continues to drop, your short puts can create large losses.

Buy Inverse ETFs

Inverse ETF’s are designed to rise when the market, sector, industry, country, or whatever they represent declines. When their underlying market advances, the inverse ETFs decline. The inverse ETF attempts to match its underlying stocks, but there is no guarantee it will do so exactly.

There is an inverse ETF for many common stock market indices, sectors, industries, currencies, and countries. Inverse ETFs are not considered long-term investments. Their underlying futures contracts are bought and sold on a daily. This frequent trading often increases the management fees, making them more costly than regular ETFs.

There are advantages to owning an inverse ETF.

• Inverse ETFs do not require the investor to hold a margin account or options account.
• They have none of the hidden costs of short selling.
• They are always available. Sometimes stocks you may want to short not be available.
• They are simple to purchase since the process is the same as buying a stock.

For more information on ETF’s see Inverse ETF’s. To evaluate and search for inverse exchange-traded funds, go to ETFdb.com where you will find a current list for this type of fund.

Buy the VIX

The VIX (Volatility Index) is a way to measure investor fear and market risk. The VIX moves up when the market is falling and drops when the market is rising. The VIX itself cannot be traded, but investors can take a position in the VIX through exchange-traded products such as the ProShares VIX Short-Term Futures (VIXY), iPath Series B S&P 500 VIX Short Term Futures (VXXB), and VelocityShares Daily Long VIX (VIIX ). For more information on the VIX, see The VIX.

 

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