How to Win When Markets Lose
For the longest time it was always my goal to make money when the markets declined. I thought that would be the ultimate proof of skill. And, if you could do this, that would allow you to increase your compounding by minimizing or even eliminating losses in your portfolio. It is possible to do so, but most of these strategies are best suited for a sophisticated investor.
This article walks through five ways investors make money when the market declines. These are rough outlines of the process, and risks, so make sure to do plenty of your own research before ever making a trade.
Short Selling
Short selling is probably the most common thing people think of when trying to make a profit on a stock decline. Short selling works by borrowing an asset and selling it. When you borrow the asset, you are obligated to return it to the owner at some point. You are betting that the price will decline, which means you can buy it back later at a lower price and return the asset to its original owner while making a profit. But if the asset rises in price far enough you will be forced to buy it at a higher price (margin called) so you can return it to the owner. This is where you can be susceptible to large losses.
There are a handful of risks with short selling, the first of all, is that you carry unlimited risk. When you normally buy a stock, it can go to $0 or it can go to infinity. Your losses are capped at $0 (despite that being a substantial loss). When short selling, since there is no upper bound on the price of the stock, in theory, your losses could be infinite.
For this reason there are rules and restrictions around short selling. Since you have to borrow the asset that you want to sell, there are restrictions on how much you can borrow and for how long. You are trading on margin, which means you need collateral to cover potential losses. Each broker and security has different rules and margin requirements.
Short selling is one of the hardest ways to make money in the markets. With all the rules, limitations, unlimited risk, and fees, you better know what you are doing before stepping into this world.
Inverse ETFs
Inverse ETFs are ETFs that track an index but perform the opposite. For example, if the S&P 500 declines by 10%, the inverse ETF (SH), would gain ~10%. There are some important things to know about inverse ETFs.
Inverse ETFs use derivatives such as futures, options, and swaps to mirror the market action. Since they don’t hold the underlying asset, there are deviations, so don’t expect to see perfect inverse relationships.
An important thing to know about these are that they reset their positions daily. This can lead to compounding errors and significant deviations from the inverse performance of the underlying index. Holding these types of funds over long time periods can lead to significant deviations from the index.
If you are going to use an inverse ETF make sure to monitor it closely and use it for short term positions (<1 month). Also be careful with leveraged inverse funds that move 2x or 3x what the index moves. These have even more risks due to the leverage they deploy. Leverage works both ways and despite the ability to make larger gains, large losses are more important to avoid.
Put Options
Options are the right (but not the obligation) to buy (call) or sell (put) a security at a set price (strike price). Options have their own market (outside of the stock market), and most are never exercised, meaning the trader is purely speculating on the price of the option itself.
A put option gives the holder the right to sell the underlying security at the strike price at any time up until the expiration date of the option. Puts work by paying out when the underlying security declines below a certain level (strike price) because you are selling your investment at a higher price than it is currently valued at.
Put options can be a very effective means of portfolio protection. They utilize leverage by 1 option contract representing 100 shares of the stock. An S&P 500 index at the money option contract with a 6-month expiration date might cost around $2,500. If you were to buy the underlying 100 shares, it would cost $40,000. That is 16x leverage on your capital!
Leverage is one of the primary benefits of options. Another is that if you are buying options, you can only lose the amount of the premium you paid. In this example, the maximum you could lose is the $2,500 you paid for the options contract. Regardless of how much the index declines, your losses are capped, while your potential gains are infinite. Options provide great asymmetric risk.
There are a significant number of risks and things to know about options before purchasing your first contract. The main risk is that options decay over time. Options have an expiration date which plays a big part in the value of the option. If you buy a stock and it goes up, down, and around, all that matters is what you paid for it, and what it is worth now.
With options, that is not the case. They are highly sensitive to changes in the price of the underlying stock, the strike price of the option, the time remaining on the contract, and the volatility of the underlying.
Be careful and do your homework before diving into options. Many a person has lost a lot of money trying to make it big with options.
Futures
A futures contract is an agreement by a buyer and seller to pay a particular price today for something to be received in the future. Futures trading is most commonly associated with commodities (wheat, oil, pigs, etc.) but there are also futures contracts on the common indices, such as the S&P 500. The standard S&P 500 futures contract is called the E-mini (ES).
An E-mini contract is valued at 50x of underlying index (SPX = $4,000, contract = $200,000). You are able to purchase futures contracts on margin so you don’t have to put up the full contract value. The standard margin rate is $12,000 per contract. So a $12,000 investment gets you access to ~$200,000 worth of capital. Also, roughly 16x leverage.
There is also a smaller version called the Micro E-mini. It is 1/10 the value of the E-mini, so 5x the value of the index and $1,200 minimum margin requirement for a single contract.
Short selling a futures contract is simpler than short selling an actual stock. It is somewhat a combination of options and regular stock trading. Futures don’t have the time decay aspect of options, but also employ leverage by using contracts. For this reason, it is sometimes the preferred method for short selling. You don’t have the asymmetric risk profile of options, but you don’t have the time decay either.
Futures trading also brings its own level of risks. Primarily dealing with margin and leverage. Leverage is a double edged sword and must be managed very carefully. People have made and lost millions overnight with futures contracts. Make sure you thoroughly review all the margin requirements and make sure you utilize stop losses to protect yourself from massive losses.
Stock Picking
Stock picking is one of the hardest games in town. But, even in overall market declines there are still usually some stocks making gains. If you do your homework, you can potentially find those stocks that are still making gains despite everything else.
Some hedge funds are “long only” which means they aren’t allowed to take short positions. For these firms, they have to focus on finding the diamonds in the rough. If you think you can find those companies that are poised to take off too, maybe stock picking is for you.
The underlying theme of making money when markets decline is that it is hard. Very hard. But not impossible. Depending on your level of competency and desired time investment, you can dive into these different options and find a way to utilize them within your overall portfolio strategy. Make sure to be wary of using margin and leverage as well as the other risks associated with these investments. Do your homework and never risk more than you can lose (and use stop losses).
