Market Downturn: Three Ways to Short the Market

Are you looking for ways to hedge against or capitalize on market downturns? Perhaps you're looking to do a little of both—that is, to hedge your current stock holdings while opening new positions to seek profit off the downside of a falling market.

Whether you're looking to protect against or profit from a bearish turn, perhaps the most direct approach is to simply "short" the market; that is, sell an asset at a higher price now, with the aim of buying back the same asset at a lower price later. It's still the same "buy low and sell high" principle that underlies all investment practices. You're just attempting to do it in reverse.

There are many ways to play the upside of a downside market. Some approaches are relatively simple, while others can be quite complex. Some approaches come with limited risks, while others may expose you to unlimited risks. For starters, here are three relatively straightforward ways to short the market using stocks, options, and futures.

Before we continue, note that in order to sell short with any of these approaches, you'll need (respectively) a margin account for stock trading, an account for which you are approved to trade options, or a futures account.

Risk: Unlimited, as there is technically no limit to a stock's upside

Aim: To seek profit from price declines

Here's a hypothetical scenario: Suppose you sense weakness in stock XYZ; its overall fundamentals appear unhealthy, and its earnings capacity seems weak. You're anticipating a decline and you aim to generate a positive return when the share price drops.

Stock XYZ is trading at $50 per share, but you think it's worth much less than its current valuation. You decide to short 100 shares, a total net position of $5,000. Then XYZ falls to $35 per share, and you "buy to cover" (i.e., buy back) 100 shares at that price. Essentially, you bought low (at $35) and sold high (at $50) 100 shares, but you did it in reverse order. Your profit before commissions, fees, margin interest or other payments, such as dividends (should they apply), would be $15 or $1,500 (15 x 100 shares).

Now, if shares of XYZ had moved in the opposite direction by the same amount—if its price had risen instead of fallen—you’d take a loss of $1,500 (more if you consider the commissions, fees, and other applicable costs). So, before you jump in, learn more about the basics of short-selling stocks.

What if your aim isn't to profit from a stock's decline but to protect your current stock positions? Can you place a direct hedge to protect your stocks? The answer is no; you can't place a direct "short" hedge to match, stock by stock, your current "long" positions.

Essentially, you can't be long and short on the same stock at the same time. However, in some cases, traders attempt to hedge their position by shorting a highly correlated stock or sector-based exchange-traded fund (ETF), although correlations aren't always stable and stock or sector prices may diverge. This isn't a direct hedge, but in some cases, assuming continuing correlation, this strategy can be used to protect some of your gains rather than liquidating your positions.

Risk: Limited if you're long an option (until the option expires)

Aim: To seek profit from price decline

One way to potentially benefit from a stock's decline would be to buy a put option, which gives the buyer the right, but not the obligation, to sell the stock at a predetermined price (the "strike" price) on or before a specific date (the expiration date of the option).

When it comes to gaining short exposure on a stock, in contrast to a straightforward short sale that exposes you to unlimited risk, the risk of buying a put is typically limited to the price—the "premium"—paid for that put. If the option is out of the money—the stock price is above the strike price—at expiration, the put option will expire worthless and 100% of the premium paid is lost.

If the stock sees a sudden drop before expiration, the premium will likely increase in value and the put option could potentially be sold for a profit. Note, however, there is no guarantee that the premium will increase even if the stock falls because other factors—such as time and volatility—affect options prices as well.

While purchasing a put may appear to be a relatively simple transaction, options contracts aren't simple instruments. There's a lot that goes into the mechanics of options trading and options pricing. Before you jump in, you'd want to review the fundamentals. For example, holding an options position until expiration can have unintended consequences. If the put option is in the money—the stock price is below the strike price—by even $0.01 at expiration, the put is subject to automatic exercise and the underlying stock will most likely be sold at the strike price, resulting in a short stock position (unless the put holder also owns the shares in their account). And, if your account doesn’t have enough money to support the resulting short stock position, your broker may, at its discretion, choose not to exercise the option. This is known as DNE ("do not exercise") instruction, and any gain you may have realized by exercising the put option will be wiped out.

Although complex, once you become familiar with options trading mechanics, you may uncover new strategies for when you forecast a downtrending market.

Risk: Unlimited, as there is technically no limit to an index or commodity's upside, or limited, if you hold the underlying instruments

Aim: To seek profit from price decline, or to hedge a portfolio of equities

Similar to shorting stocks, you can sell (short) a futures contract to attempt to profit from an anticipated price decline of an index, commodity, or currency. Because futures include "equity" indexes like the S&P 500^®, Dow Jones Industrial Average^®, and Nasdaq-100^®, you can also short indexes to hedge your equities positions, as long as the number of short futures contracts matches the size of the equities positions and the index accurately reflects the composition and weighting of the stocks within the portfolio.

Bear in mind, futures trading can be exceedingly risky and is not for every investor or trader. Futures are highly leveraged instruments, which means futures can be capital-efficient but also that it takes very little money to gain a lot of exposure…and things can move quickly. Profits and losses are amplified. And because you're trading on margin and using leverage that exceeds what's typically available for stocks, you're responsible for instruments where the total value can exceed the amount of capital in your trading account. If you're not careful, you can lose more money than you have.

Markets run in cycles—sometimes up; sometimes down. The good news is that there are tools available to investors who choose to try to take advantage of, or protect themselves from, the market’s downside. If you think short strategies may be right for you, it's important to understand the risks as well as the potential benefits.