In stock investing, the ultimate goal is to buy low and sell high. That’s essentially how you make money.
As the saying goes, though, there’s more than one way to skin a cat. There are different ways to achieve that goal.
When the stock market goes up, the sailing is smooth. If you buy some blue-chip stocks as core holdings, and then perhaps to take some chances on speculative stocks with high potential upside, chances are you will make money.
But when the market is falling, things get trickier. If you are in it for the long haul, selling everything is not a good idea. You’ll want to keep your best stocks. Remember, even as scary as the Financial Crisis and—more recently—the Covid lockdown market crashes were, investors who hung on made back their money and then a lot more.
Find Ways to Make Money in Down Market
When things are crashing, investors who want to be more proactive can still make money by betting on the short side. Two main ways to do this are to short stocks and ETFs and to buy put options.
The idea is still to buy low and sell high. The difference in the case of shorting is you sell first and then buy back to cover. If you are right, you would be able to buy back at a lower price than you shorted the stock.
As for put options, you are buying first and then selling, like a regular stock trade. A put option gives the holder the right to sell the underlying security at a specified price, so if the underlying security falls in price, the value of the option would go up, assuming there’s enough time left to expiration—more on this later.
So the question is, if you want to bet against the market, should you short stocks or buy options? Let’s take a look at a few key things to keep in mind.
Stock Shorting vs. Put Buying
A big advantage when you short a stock instead of buying a put is that you get a cash inflow. You can use that cash to invest in something else. For example, even if you don’t want to risk that cash, you could simply invest the cash in a money market fund and earn a small return.
You are earning an extra return with borrowed money. If you are more aggressive, you can invest the money in riskier assets in pursuit of a higher return, as long as you satisfy the broker’s margin requirements.
It’s not all roses, however. If the market moves significantly against you, you could face the unpleasantness of a margin call. This means that the broker demands you increase your equity in the account, the percentage of the account value that’s your own money. You would need to deposit more cash into the account, and/or buying to close out short positions.
If you take no action, the broker will forcibly close positions for you. For people caught in the so-called short squeeze—when short sellers are forced to buy back whatever they shorted, which drives the price further upward—things can snowball and get ugly very quickly. In addition, depending on the broker’s policy, you may owe interest since you are borrowing.
The Advantage of Puts
When you buy a put option, you cap your potential loss. The most you could lose is the premium, the amount you paid for the put. Furthermore, if the underlying stock falls, provided there’s enough time left on the put option before expiration, your gains could be larger with a put.
For example, consider two scenarios. Scenario A, you short 20 shares of a $50 stock for $1,000. Scenario B, you use the $1,000 buy 10 contracts of a November $48 put, which expires in approximately three months, for $1. Let’s say over the next month, the stock drops 20% to $40. If you cover your short position for $800 ($40 x 20 shares) at that point, you make $200, or 20%. In fact, the maximum possible gain you can get is 100%. That occurs if the stock drops to zero.
In the case of the put option, the intrinsic value (the difference between strike price and market price) alone would be $8 per underlying share, or $800 per contract. Plus, with two months left to expiration, there’s plenty of time value left. So let’s say you are able to sell the November $48 put for $8.25, or $8,250, your profit would be a cool $7,250, or about 36 times higher than Scenario A!
To keep things simple, in the example I ignored things like trading cost, margin interest, and investments you could have made with the cash inflow from shorting. The important point to note is that if the stock moves strongly in your favor, your profits could be much higher in the case of a put versus a short.
You must keep in mind, however, that a put option expires. That’s the biggest knock against options. There is a limited amount of time for your trade to work out. And if the stock falls but doesn’t fall sharply or quickly enough, you could be right about the stock’s direction but still lose on the trade.
Editor’s Note: Does uncertainty in the financial markets have you on edge? The key to mastering risk resides in what our colleague Jim Pearce calls “Mayhem Trades.”
Jim Pearce is chief investment strategist of our premium trading service, Mayhem Trader. Jim has developed an under-the-radar strategy to flip market mayhem into fast payouts. Want to learn more? Click here now.
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