At first, the idea that traders can bet against the stock market might seem ludicrous. Why would they profit from failure? Are they actually rooting against good fortune? Do they truly want pillars of the economy to collapse?
It’s nothing that nefarious. Hedging against market downturns isn’t an act of hostility or cynicism — it’s protection.
In this post, Gorilla Trades examines why and how to bet against the stock market with trading instruments solely created to survive and profit from stock price declines. We’ll take a look at a few methods and how they work. Crucially, we’ll also talk about the considerable risk in betting against stocks.
Short Selling: The “Traditional” Way to Bet Against the Stock Market
The most basic form of betting against the market is short selling. It’s been around in some form for over 400 years. Its origins are in the Dutch East India Company, which is credited as the world’s first stock exchange.
Short selling gives investors a way to profit from a stock’s fall. Sometimes it’s a form of speculation; other times, traders use it to hedge against other risks. Though it’s the most common form of shorting (shorthand for betting against the market), it’s still highly unconventional.
How Short Selling Works
Suppose that a trader believes a certain stock’s price is over-inflated. They believe the price is due for a drop, and they want to profit. So they “borrow” shares of the stock from their brokerage’s share pool — if it’s allowed — and sell them at their current price on the open market.
Then, if the price goes down as the trader expected, they can buy the shares back at the newly reduced price. They then give the borrowed stocks back to the brokerage and keep the difference in price as a profit.
Short Selling In Action: An Example
Imagine there’s a company called Acme Anvils (fake stock ticker NYSE:AVIL) with a current share price of $90 per share. You think the anvil market is going to drop.
So you borrow 100 shares from your broker and immediately sell them to another party at the $90 price. One month later, it happens — AVIL’s stock price plummets to $60. You buy the AVIL shares back at that price and return them to the brokerage.
When you sold the borrowed shares, you earned $9,000 ($90 x 100). When you bought them back, you only paid $6,000 ($60 x 100). After returning the shares to the brokerage, you net a profit of $3,000 that you get to keep.
That’s if the price goes down as expected. But it stays the same or increases, you’re stuck. You have to buy the shares back at their elevated price — essentially, you’ll be out $9,000, or more if the price goes up.
This second scenario is emblematic of the biggest problem with shorting of any kind: It’s extremely risky. Some brokerages — notably, Robinhood — don’t even allow short selling. Those who do allow it have strict regulations.
For example, the trader has to have a margin account, essentially a vehicle for borrowing from the broker. The stakes are too high for cash-only accounts. The broker might also require you to keep a minimum balance or review your transaction history to see how much experience you have.
Put Options
Short selling is the traditional way to bet against the stock market, but put options may be slightly less risky. With put options, you don’t have to repurchase the stock shares at the end of the cycle.
A put option is essentially a contract you buy for a premium. The contract gives you the option — not the obligation — to sell a certain stock at a predetermined price (called the “strike price”) before a specified date. If the price goes down before that date, you resell the shares at the agreed-upon strike price and keep the revenue.
Let’s use Acme Anvil again as an example. You buy a put option on AVIL stock and set a strike price of $90, its current share value. Most put option contracts cover 100 shares. The put option costs you a premium of $5 a share, so you spend a total of $500 for the put option. The contract expires in one month — you have 30 days to decide whether to sell the shares or not.
Within the month, AVIL shares drop to $75. You buy 100 shares at that price. Then, you execute your option to sell the 100 shares at your $90 strike price, even though they’re now $75 each. That’s a difference of $15 per share, so you earn $1,500. Subtracting the $500 premium, your net profit on the put option is $1,000.
With put options, it’s more common for traders to sell the contract itself when share prices decline. The put option also gains value, so selling it still nets you profit without you having to go through the process of buying 100 shares. It’s simpler.
Of course, if the share price goes up, you lose the premium. But that’s less catastrophic than losing the entire value of the 100 shares.
Other Ways to Bet Against the Stock Market
Short selling and put options are the two most common methods of shorting, and they’re most appropriate for retail investors. Experienced traders and institutional investors have a few other options to bet against the stock market.
Futures Contracts
Futures contracts are a little like put options — except they’re not options, they’re obligations. A futures contract is an agreement to sell a certain commodity at a certain price by a certain time. Unlike put options, futures contracts focus on the commodity itself — oil, wheat, corn — rather than shares, though some futures contracts cover indexes like the S&P 500.
For example, you can buy a futures contract obligating you to sell 100 barrels of crude at $75 each within 30 days. If the barrel value drops below $75, you profit. But if the price goes up, you’re obligated to sell the commodity at a loss. Because of the scale, futures contracts are generally for institutional investors. They’re not for beginning or even most individual investors.
Inverse ETFs
Just like regular exchange-traded funds (ETFs), inverse ETFs are publicly traded and accessible through brokerage accounts. However, inverse ETFs are designed to gain in value when a market index falls. Fund managers use derivatives like swaps and futures contracts to generate reverse returns on the falling index’s performance.
Inverse ETFs are available to all — you don’t need a margin account or minimum balance to get one. However, they’re almost exclusively for short-term trading. If you hold onto an inverse ETF for a long time, compounding decays can lead to big losses.
Contracts for Differences (CFDs)
CFDs are a little like futures contracts on steroids. While futures contracts are obligations to sell commodities at a set price, CFDs are cash-settled contracts tracking the underlying asset’s price. CFDs are leveraged, meaning traders control larger positions with less upfront capital. That makes the potential for gains much greater; however, it also amplifies the possibility of gigantic losses.
In fact, CFDs are so risky that they’re completely illegal in the United States. They’re legal in Canada, but heavily regulated. However, CFDs are popular with other international brokerages.
Place Your Bets With Gorilla Trades
There are many creative ways for investors to bet against the stock market, including short selling, put options, and other inverse strategies. When you’re looking for time-proven financial strategies that generate real returns, it’s good to have a helping hand on your side.
Gorilla Trades helps our clients find great opportunities for profits in stock trading. To find out how, sign up for a risk-free trial and 30 days of free stock alerts.
