If You’re Going to Bet Against the Market, Read This First

While all investors know stock prices move both up and down, many only utilize strategies that take advantage of rising prices.

Buy-and-hold investors benefit from a long-term uptrend in the stock market. Over periods of 20 years or more, investors expect stocks to deliver average annual gains of 7%-10%. Confident that those gains will be realized, many investors hold onto positions even in bear markets.

Since the stock market topped in 2000, buy-and-hold investors suffered through two losses of 50% or more. Losses of this size are actually to be expected in bear markets. After the market topped in 1929, for example, investors also suffered through two declines of more than 50% before the uptrend resumed.

While not exactly out of the ordinary, large losses can force investors to delay their retirements or adapt to new personal financial circumstances in other ways. This has led some investors to explore strategies that will allow them to benefit from market declines. There are several ways to do so, although many ultimately lead to losses.

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Selling short is probably the most commonly known way to profit from a decline. It’s an appealing idea but is unlikely to be profitable for most investors. When you sell short, you are selling stock that you do not own. Your broker lends you the shares to sell, and you will buy the stock in the future to repay the loan. If the price falls, you will pay less to buy the shares than you received when you sold them, and that will be your profit on the trade.

Short selling is a strategy with high costs and high risk. In addition to commissions, you will have to pay interest to your broker for lending you the shares. Short sellers are also responsible for paying any dividends that are distributed while they are holding a short position. These costs can be significant, and if the stock rises, the potential losses for a short seller are unlimited.

Trading the CBOE Volatility Index (VIX) is another way some traders attempt to profit from a decline. Volatility, measured by VIX, rises when prices fall. However, VIX is an index and cannot be traded directly. Futures contracts, options and ETNs that offer exposure to VIX have large tracking errors, and their price changes will generally be smaller than the move seen in VIX.

Products based on VIX also tend to have high costs, and these costs push the price down over time. Over the long term, ETNs based on VIX have suffered large declines and will likely continue to do so because of the cost structure.

Buying put options is probably the best way to benefit from a market decline. Put options give the buyer the right to sell 100 shares of a stock or ETF at a certain price before a certain date. Put buyers profit when prices fall because put option prices typically increase in a market decline.

The price of an option is determined by a variety of factors, one of which is the price of the underlying stock or ETF. Options on high-priced equities like Apple (NASDAQ: AAPL) and SPDR S&P 500 ETF (NYSE: SPY) will be more expensive than options on lower priced stocks. This means that investors could see larger gains, on a percentage basis, using put options on lower priced stocks or ETFs.

When considering index ETFs, one of the most profitable put options trades in a market decline could be First Trust NASDAQ-100 Equal Weight Index (NASDAQ: QQEW). 

To minimize the risk, wait for a downtrend in the stock market to be confirmed. This strategy could be implemented when SPY closes below its 50-day moving average.